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CHAPTER

323

9TIME VALUE ANALYSIS

Learning Objectives
After studying this chapter, readers will be able to

• Explain why time value analysis is so important to healthcare
financial management.

• Find the present and future values for lump sums, annuities, and
uneven cash flow streams.

• Explain and apply the opportunity cost principle.
• Measure the financial return on an investment in both dollar and

percentage terms.
• Describe and apply stated, periodic, and effective annual interest

rates.

Introduction

The financial (monetary) value of any asset, whether it is a financial asset, such
as a stock or a bond, or a real asset, such as a piece of diagnostic equipment or
an ambulatory surgery center, is based on future cash flows. A dollar in hand
today is worth more than a dollar to be received in the future because a dollar
today can be used for immediate consumption, whereas a dollar expected in
the future cannot. If investment opportunities exist, a dollar to be received in
the future is worth less than a current dollar because a dollar in hand today
can be invested in an interest-bearing account and hence can be worth more
than one dollar in the future. Because current dollars are worth more than
future dollars, financial management decisions must account for cash flow
timing differences.

The process of assigning appropriate values to cash flows that occur at
different points in time is called time value analysis. It is an important part
of healthcare financial management because most financial investment analy-
ses involve the valuation of future cash flows. In fact, of all the financial analy-
sis techniques discussed in this book, none is more important than time value
analysis. The concepts presented here are the cornerstones of most financial
investment analyses, so a thorough understanding of time value concepts is

time value
analysis
The use of time
value of money
techniques to
value future cash
flows; sometimes
called discounted
cash flow analysis.

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CHAPTER

3

HEALTHCARE FINANCE BASICS

Learning Objectives
After studying this chapter, readers will be able to

• Describe the organization of this book and the learning aids
contained in each chapter.

• Define the term healthcare finance as it is used in this book.
• Describe the key characteristics of a business.
• Discuss the structure of the finance department, the role of

finance in health services organizations, and how this role has
changed over time.

• Describe the major players in the health services sector.
• List the key operational issues currently faced by healthcare

managers.
• Describe the forms of business organization and corporate

ownership and their organizational goals.
• Discuss the key elements of healthcare reform and its expected

effect on the provision of health services.

Introduction

In today’s healthcare environment, where financial realities play an important
role in health services decision-making, it is vital that managers at all levels
understand the basic concepts of healthcare finance and how these concepts
are used to enhance the financial well-being of the organization. In this chap-
ter, we introduce readers to the book, including its purpose, goals, and orga-
nization. Furthermore, we present some basic background information about
healthcare finance and the health services system. We sincerely hope that this
book will help you in your quest to increase your professional competency in
the important area of healthcare finance.

1

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G apenski ’s Healthcare F inance4

Before You Begin

Before you begin the study of healthcare finance, here are a few tips about
the book that will make the process easier.

Purpose of the Book
Many books cover the general topics of accounting and financial manage-
ment, so why is a book needed that focuses on healthcare finance? The reason
is that while all industries have certain individual characteristics, the health
services sector is truly unique. For example, the provision of many healthcare
services is dominated by not-for-profit corporations, both private and govern-
mental; such entities are inherently different from investor-owned businesses.
Also, the majority of payments made to healthcare providers are not made by
the individuals who use the services but by third-party payers (e.g., employ-
ers, commercial insurance companies, government programs). Throughout
this book, the ways in which the unique features of the health services sector
influence the application of finance principles and practices are emphasized
and supported by examples.

This book is designed to introduce students to healthcare finance.
This design has two important implications. First, the book assumes no prior
knowledge of the subject matter; thus, the book is totally self-contained,
with each topic explained from the beginning in basic terms. Furthermore,
because clarity is so important when concepts are introduced, the chapters
are written in an easy-to-read style. None of the topics is inherently difficult,
but new concepts often take effort to understand. This process is made easier
by the writing style used in the book.

Second, because this book is introductory, it contains a broad over-
view of healthcare finance. The good news is that the book presents virtually
all the important healthcare finance principles used by managers in health ser-
vices organizations. The bad news is that the large number of topics covered
prevents us from covering principles in great depth or from including a wide
variety of illustrations. Thus, students who use this book are not expected
to fully understand every nuance of every finance principle and practice that
pertains to every type of health services organization. Nevertheless, this book
provides sufficient coverage of healthcare finance concepts so that readers will
be better able to function as managers, judge the quality of financial analyses
performed by others, and incorporate sound principles and practices into
their own personal finance decisions.

Naturally, an introductory finance book cannot contain everything that
healthcare financial managers must know to competently perform their jobs.
Nevertheless, the book is useful even for those working in finance positions

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Chapter 1 : Healthcare F inance Basics 5

within health services organizations because it presents an overview of the
finance function. Often, when working in a specific area of finance, it is easy to
lose sight of the context of the work. This book will help provide that context.

Organization of the Book
To ensure that this book meets its goals, the destination has been carefully
charted: to provide an introduction to healthcare finance. The book is orga-
nized into the following parts to pave the road to this destination.

Part I, The Healthcare Environment, contains fundamental back-
ground material that is essential to the practice of healthcare finance. Part I
introduces the book, provides insights into the unique nature of the health
services field, and provides additional information on how healthcare provid-
ers obtain their revenues. Healthcare finance cannot be studied in a vacuum
because the practice of finance is profoundly influenced by the economic and
social environment of the field, including the different types of ownership
and reimbursement methods.

Part II, Financial Accounting, begins the actual discussion of health-
care finance principles and practices. Financial accounting, which involves the
creation of statements that summarize a business’s financial status, is most
useful for outsiders and for long-term planning and management. In this
part, we discuss the format and interpretation of the four primary financial
statements and provide an overview of the double-entry accounting system
used to record financial accounting transactions.

Part III, Managerial Accounting, which consists of four chapters,
focuses on the creation of data used in the day-to-day management and
control of a business. Here, the emphasis is on the overall organization,
before shifting to the subunit (department) level and then to the individual
service level. The key topics in part III include costing methods and behavior,
profit planning, cost allocation, pricing decisions, and financial planning and
budgeting.

In part IV, Basic Financial Management Concepts, the focus moves
from accounting to financial management. In the first of two chapters, we
cover time value analysis, which provides techniques for valuing future cash
flows. In the second chapter, we discuss financial risk and required return.
Taken together, these chapters provide readers with knowledge of two of the
most important concepts used in financial decision-making.

Part V, Long-Term Financing, turns to the capital acquisition process.
Businesses need capital, or funds, to purchase assets, and this part examines
the two primary types of financing—long-term debt and equity. In addition,
the final chapter of part V provides the framework for analyzing a business’s
appropriate financing mix and assessing its cost.

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G apenski ’s Healthcare F inance6

Part VI, Capital Investment Decisions, considers the vital topic of how
businesses analyze new capital investment opportunities (capital budgeting).
Because major capital projects take years to plan and execute, and because
these decisions generally are not easily reversed and will affect operations for
many years, their impact on the future of an organization is profound. The
two chapters in this part first focus on basic capital investment analysis con-
cepts and then turn to project risk assessment and incorporation.

Part VII, Other Topics, covers two diverse topics. The first chapter
in this part discusses the revenue cycle and the management of short-term
assets, such as cash and inventories, as well as how such assets are financed.
The techniques used to analyze a business’s financial and operating condi-
tion are discussed in the book’s final chapter. These topics are presented
last because students may benefit from an overview of the other concepts
in the book before embarking on these chapters. However, instructors may
also choose to combine these chapters with other parts of the book. For
example, chapter 16, Revenue Cycle and Current Accounts Management,
may be taught near the chapters in part V as this would present students
with a picture of the management of short-term versus long-term accounts.
Chapter 17, Financial Condition Analysis, may be taught with the financial
accounting chapters in part II since much of the chapter involves the analysis
of financial accounting data.

Health services managers must be able to assess the current financial
condition of their organizations. Even more important, managers must be
able to monitor and control current operations and assess ways in which
alternative courses of action will affect the organization’s future financial
condition.

How to Use This Book
As mentioned earlier, this book is designed to introduce students to health-
care finance. It contains several features designed to make the process as easy
as possible.

First, pay particular attention to the Learning Objectives listed at the
beginning of each chapter. These objectives highlight the most important
topics in each chapter and identify readers’ learning goals for the chapter.

Following each major section in a chapter (except the chapter’s intro-
duction), one or more Self-Test Questions are included. As you finish reading
each major section, try to answer these questions. Your responses do not have
to be perfect, but if you are not satisfied with your answer, reread the section
before proceeding. Answers are not provided for the self-test questions, so
a review of the section is necessary if you are not sure whether your answers
are satisfactory.

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Chapter 1 : Healthcare F inance Basics 7

It is useful for readers to have important equations both embedded in
the text to illustrate their use and broken out separately for easy identification
and review. The Key Equation boxes can be used for both section and chap-
ter review and as an aid to solving the end-of-chapter problems. The book
contains several additional types of boxes, such as For Your Consideration and
Healthcare in Practice boxes. Each of these boxes presents an important issue
that is relevant to the text discussion and allows readers to pause to think
about the issue presented, generate opinions, and draw conclusions. Many
instructors use these boxes to stimulate in-class discussions.

Within the book, italics and boldface are used to indicate importance.
Italics are used whenever a key term is introduced; thus, italics alert readers
that a new and important concept is being presented. Italics are also used
occasionally for emphasis. Boldface indicates terms that are defined in each
chapter’s running glossary, which complements the glossary at the back of
the book. Boldface is also used occasionally for emphasis.

In addition to the in-chapter learning aids, materials designed to help
readers learn healthcare finance are included at the end of each chapter.
First, each chapter ends with a section titled Key Concepts, which summarizes
the most important principles and practices covered in that chapter. If the
meaning of a key concept is not clear, you may find it useful to review the
applicable section. Each chapter also contains a series of Questions designed to
assess your understanding of the qualitative material in the chapter. In most
chapters, the questions are followed by a set of Problems designed to assess
your understanding of the quantitative material.

Some chapters conclude with a set of Selected Cases from Gapenski’s
Cases in Healthcare Finance, sixth edition, that illustrate practical applications
of healthcare finance. Additionally, each chapter includes a set of Resources.
The books and articles cited can provide a more in-depth understanding of
the material covered in the chapter. Finally, some chapters contain a Chapter
Supplement, whose purpose is to present additional information pertaining to
topics in the chapter that is useful but not essential.

Taken together, the pedagogic structure of the book is designed to
make learning healthcare finance as easy and enjoyable as possible.

1. Why is it necessary to have a book dedicated to healthcare
finance?

2. What is the purpose of this book?
3. Briefly describe the organization of this book.
4. What features of this book are designed to make learning easier?

SELF-TEST
QUESTIONS

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G apenski ’s Healthcare F inance8

Defining Healthcare Finance

What is healthcare finance? Surprisingly, there is no single answer to that
question because the definition of the term depends, for the most part, on
the context in which it is used. Thus, in writing this book, the first step was
to establish a definition of healthcare finance.

We began by examining the healthcare sector of the economy, which
consists of a diverse collection of subsectors that involve, either directly or
indirectly, the healthcare of the population. The major subsectors of health-
care include the following:

• Health services. The health services subsector consists of providers of
health services, including medical practices, hospitals, nursing homes,
home health care agencies, and hospice providers.

• Health insurance. The health insurance subsector, which makes most
of the payments to health services providers, includes government
programs, commercial insurers, and self-insurers. Also included here
are managed care companies, such as health maintenance organizations
(HMOs), which incorporate both insurance and health services
(provider) functions.

• Medical equipment and supplies. These subsectors include the makers
of diagnostic equipment, such as X-ray machines; durable medical
equipment, such as wheelchairs; and expendable medical supplies, such
as disposable surgical instruments and hypodermic syringes.

• Pharmaceuticals and biotechnology. These subsectors develop and
market drugs and other therapeutic products.

• Other. This broad category includes organizations such as consulting
firms that advise hospitals on strategy and operations, educational
institutions that train providers and healthcare managers, government
agencies that regulate various health services subsectors, and private
agencies that provide a wide variety of services.

Most users of this book will become (or already are) managers at
health services organizations or at companies such as insurance and consult-
ing firms that deal directly with health services organizations. Thus, to give
this book the most value to its primary users, we focus on finance as it applies
within the health services subsector.

Now that we have defined the healthcare focus of this book, the term
finance must be defined. Finance, as the term is used within health services
organizations and as it is used in this book, consists of both the account-
ing and financial management functions. (In many settings, accounting and
financial management are separate disciplines.) Accounting, as the term

provider
An organization
that provides
healthcare
services (treats
patients).

accounting
The field of finance
that involves
the measuring
and recording of
events, in dollar
terms, that reflect
an organization’s
operational and
financial status.

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Chapter 1 : Healthcare F inance Basics 9

implies, is concerned with the recording, in financial terms, of economic
events that reflect the operations, resources, and financing of an organization.
In general, the purpose of accounting is to create and provide to interested
parties, both internal and external, useful information about an organiza-
tion’s operations and financial status.

Whereas accounting provides a rational means by which to measure
a business’s financial performance and assess operations, financial manage-
ment provides the theory, concepts, and tools necessary to help managers
make better financial decisions. Of course, the boundary between account-
ing and financial management is blurry; certain aspects of accounting involve
decision-making, and much of the application of financial management
theory and concepts requires accounting data.

1. What is meant by the term healthcare finance?
2. What is the difference between accounting and financial

management?

SELF-TEST
QUESTIONS

The Concept of a Business

This book focuses on finance as it is practiced within health services busi-
nesses, so it is reasonable to ask, What is a business?

In this book, we define a business from a financial (economic) per-
spective. A business can be thought of as an entity (its legal form does not
matter) that (1) obtains financing (capital) from the marketplace; (2) uses
those funds to buy land, buildings, and equipment; (3) operates those assets
to create goods or services; and then (4) sells those goods or services to
create revenue. To be financially viable, a business has to have sufficient
revenue to pay all of the costs associated with creating and selling its goods
or services.

Although this description of a business is surprisingly simple, it tells a
great deal about the basic decisions that business managers must make. One
of the first decisions is to choose the best legal form for the business. Then,
the manager must decide how the business will raise the capital that it needs
to get started. Should it borrow the money (use debt financing), raise the
money from owners (or from the community if it is a not-for-profit organiza-
tion), or use some combination of the two sources? Next, once the start-up
capital is raised, what physical assets (facilities and equipment) should be
acquired to create the services that (in the case of healthcare providers) will
be offered to patients?

financial
management
The field of finance
that provides the
theory, concepts,
and tools used
by healthcare
managers to make
financial decisions.

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G apenski ’s Healthcare F inance10

Note that businesses are profoundly
different from pure charities. A business,
such as a hospital or medical practice,
sustains itself financially by selling goods
or services. Thus, it is in competition with
other businesses for the consumer dol-
lar. A pure charity, such as the American
Heart Association, does not sell goods or
services. Rather, it obtains funds by solic-
iting contributions and then uses those
funds to supply charitable (free) services.
In essence, a pure charity is a budgetary
organization in that the amount of contri-
butions fixes its budget for the year.

Businesses are also different from
government agencies such as local public
health departments. In general, govern-
ment agencies do not receive revenues by
selling services or soliciting contributions.
Rather, their revenues are derived from tax-
ing the populations that benefit from the
government services, so providing addi-
tional services typically uses resources with-
out generating additional income. Thus,
like a pure charity, a government agency
has a budget that is fixed, but by appro-
priations rather than by contributions.

1. From a financial perspective, briefly describe a business.
2. What is the difference between a business and a pure charity?

Between a business and a government agency?

SELF-TEST
QUESTIONS

The Role of Finance in Health Services Organizations

The primary role of finance in health services organizations, as in all busi-
nesses, is to plan for, acquire, and use resources to maximize the efficiency
and value of the organization. As we discuss in the next section, the two
broad areas of finance—accounting and financial management—are separate
functions in larger organizations, although the accounting function usually

For Your Consideration
Businesses, Pure Charities,

and Government Entities

A healthcare business relies on revenues from
sales to create financial sustainability. For
example, if a hospital’s revenues exceed its costs,
cash is being generated that can be used to pro-
vide new and improved patient services, and the
hospital can continue to meet community needs.
On the other hand, pure charities, such as United
Way, rely on contributions for their revenues, so
the amount of charitable services provided (which
typically are free) is limited by the amount of
contributions received. Finally, most government
units are funded by tax receipts; therefore, as
with charities, the amount of services provided is
limited, but in this case by the taxing authority’s
ability to raise revenues. In spite of these differ-
ences, all three types of organizations must oper-
ate in a financially prudent manner.

What do you think? From a finance perspec-
tive, how different are these types of organiza-
tions? How does the day-to-day functioning of
their respective finance departments vary? Is
finance more important in one type of organiza-
tion than in another?

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Chapter 1 : Healthcare F inance Basics 11

is carried out under the direction of the organization’s chief financial officer
and hence falls under the overall category of finance.

In general, finance activities include the following:

• Planning and budgeting. First and foremost, healthcare finance
involves evaluating the financial effectiveness of current operations and
planning for the future. Budgets play an important role in this process.

• Financial reporting. For a variety of reasons, it is important for
businesses to record and report to outsiders the results of operations
and current financial status. This is typically accomplished by a set of
financial statements.

• Capital investment decisions. Although capital investment is typically
handled by senior management, managers at all levels must be concerned
with the capital investment decision-making process. Decisions that
result from this process, which are called capital budgeting decisions,
focus on the acquisition of land, buildings, and equipment. They are the
primary means by which businesses implement strategic plans, and hence
they play a key role in an organization’s financial future.

• Financing decisions. All organizations must raise capital to buy the
assets necessary to support operations. Such decisions involve the
choice between internal and external funds, the use of debt versus
equity capital, the use of long-term versus short-term debt, and the
use of lease versus conventional financing. Although senior managers
typically make financing decisions, these decisions have ramifications for
managers at all levels.

• Revenue cycle and current accounts management. Revenue cycle
management includes the billing and collections function, while
current accounts management involves the organization’s short-term
assets, such as cash and inventories, and short-term liabilities, such
as accounts payable and debt. Such functions and accounts must be
properly managed both to ensure operational effectiveness and to
reduce costs. Generally, managers at all levels are involved to some
extent in revenue cycle and current accounts management.

• Contract management. In today’s healthcare environment, health
services organizations must negotiate, sign, and monitor contracts with
managed care organizations and third-party payers. The financial staff
typically has primary responsibility for these tasks, but managers at all
levels are involved in these activities and must be aware of their effects
on operating decisions.

• Financial risk management. Many financial transactions that take place to
support the operations of a business can themselves increase the business’s
risk. Thus, an important finance activity is to control financial risk.

budget
A detailed plan,
in dollar terms, of
how a business
and its subunits
will acquire and
use resources
during a specified
period of time.

financial
statements
Statements
prepared by
accountants
that convey the
financial status of
an organization.
The four primary
statements are the
income statement,
balance sheet,
statement of
changes in equity,
and statement of
cash flows.

capital budgeting
The process of
analyzing and
choosing new
long-term assets
such as land,
buildings, and
equipment.

capital
The funds raised
by a business that
will be invested
in assets, such as
land, buildings,
and equipment
that support the
organizational
mission.

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G apenski ’s Healthcare F inance12

These specific finance activities can be summarized by the four Cs:
costs, cash, capital, and control. The measurement and minimization of costs
is vital to the financial success of any business. Cash is the “lubricant” that
makes the wheels of a business run smoothly—without it, the business grinds
to a halt. Capital represents the funds used to acquire land, buildings, and
equipment. Without capital, businesses would not have the physical resources
needed to provide goods and services. Finally, a business must have adequate
control mechanisms to ensure that its capital is being wisely employed and its
physical resources are protected for future use.

In times of high profitability and abundant financial resources, the
finance function tends to decline in importance. Thus, at the time when most
healthcare providers were reimbursed on the basis of costs incurred, the role
of finance was minimal. The most critical finance function was cost identifica-
tion because it was more important to account for costs than it was to control
them. In response to payer (primarily Medicare) requirements, providers
(primarily hospitals) churned out a multitude of reports both to comply with
regulations and to maximize revenues. The complexities of cost reimburse-
ment meant that a large amount of time had to be spent on cumbersome
accounting, billing, and collection procedures. Thus, instead of focusing on
value-adding activities, most finance work focused on bureaucratic functions.

Now, finance functions are typically much more strategic and sophisti-
cated in recognition of the changes that have occurred in the health services
sector. Although billing and collections remain important, to be of maximum
value to the enterprise today, the finance function must support a much broader
array of activities, including strategy development, cost containment efforts,
third-party payer contract negotiations, joint venture decisions, risk manage-
ment, and clinical integration. In essence, finance must help lead organizations
into the future rather than merely record what has happened in the past.

In this book, the emphasis is on the finance function, but there are no
unimportant functions in healthcare organizations. Senior executives must
understand a multitude of other functions, such as operations, marketing,
facilities management, quality improvement, and human resource manage-
ment, in addition to finance. Still, all business decisions have financial impli-
cations, so all managers—whether they are in finance or not—must know
enough about finance to properly incorporate any financial implications into
decisions made within their own specialized areas.

1. What is the role of finance in today’s health services organizations?
2. How has this role changed over time?
3. What are the four Cs?

SELF-TEST
QUESTIONS

four Cs
A mnemonic for
the four basic
finance activities:
costs, cash,
capital, and
control.

cost
A resource use
associated with
providing or
supporting a
specific service.

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Chapter 1 : Healthcare F inance Basics 13

The Structure of the Finance Department

The size and structure of the finance department within health services
organizations depend on the type of provider and its size. Still, the finance
department within larger provider organizations generally follows the model
described here.

The head of the finance department holds the title chief financial
officer (CFO) or sometimes vice president of finance. This individual typi-
cally reports directly to the organization’s chief executive officer (CEO) and is
responsible for all finance activities within the organization.

The CFO directs two senior managers who help manage finance activi-
ties. First is the comptroller (pronounced, and sometimes spelled, “control-
ler”), who is responsible for accounting and reporting activities such as routine
budgeting, preparation of financial statements, payables management, and
patient accounts management. For the most part, the comptroller is involved
in the activities covered in chapters 3–8 of this text. Second is the treasurer,
who is responsible for the acquisition and management of capital (funds).
The treasurer’s activities include the acquisition and employment of capital,
cash and debt management, lease financing, financial risk management, and
endowment fund management (within not-for-profits). In general, the trea-
surer is involved in the activities discussed in chapters 11–17 of this text.

Of course, in larger organizations, the comptroller and treasurer
have managers with responsibility for specific functions, such as the patient
accounts manager, who reports to the comptroller, and the cash manager,
who reports to the treasurer.

In very small businesses, many of the finance responsibilities are com-
bined and assigned to just a few individuals. In the smallest health services
organizations, the entire finance function is managed by one person, often
called the business (practice) manager.

1. Briefly describe the typical structure of the finance department
within a health services organization.

2. How does the structure of the finance department differ between
small and large health services organizations?

SELF-TEST
QUESTIONS

Health Services Settings

Health services are provided in a variety of settings, including hospitals,
ambulatory care facilities, long-term care facilities, and even at home.

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G apenski ’s Healthcare F inance14

Before the 1980s, most health services organizations were independent
and not formally linked with other organizations. Those that were linked
tended to be part of horizontally integrated systems that controlled a
single type of healthcare facility, such as hospitals or nursing homes. Over
time, however, many health services organizations have diversified and
become vertically integrated through either direct ownership or contractual
arrangements.

Most readers of this text are familiar with health services settings either
through previous courses or work in the field. For readers who have not
had exposure to health services settings, the chapter 1 supplement, available
online at ache.org/books/HCFinance7, provides additional information.

1. Name a few settings in which health services are provided.
2. Briefly describe horizontal and vertical integration.

SELF-TEST
QUESTIONS

Current Managerial Challenges

In recent years, the American College of Healthcare Executives has surveyed
CEOs regarding the most critical concerns of healthcare managers. Finan-
cial concerns have headed the list of challenges every year since the survey
began in 2002. When asked to rank their specific financial concerns, in 2018,
CEOs put costs for staff, supplies, and other expenses; Medicaid reimburse-
ment; and operating costs at the forefront.1 (Reimbursement is discussed in
chapter 2.)

In a survey of senior healthcare executives conducted by the Advisory
Board in 2019, respondents reported that their most pressing issues were
revenue growth, population health, and accountable care organization strat-
egy and cost containment.2 Finally, a survey conducted by the Healthcare
Financial Management Association identified improving the accuracy of clini-
cal documentation as a key revenue cycle (billing and collecting on a timely
basis) concern.3

Taken together, the results of these surveys confirm that finance is of
primary importance to today’s healthcare managers. The remainder of this
book is dedicated to helping you confront and solve these issues.

1. What are some important issues facing healthcare managers today?
SELF-TEST
QUESTION

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Chapter 1 : Healthcare F inance Basics 15

Legal Forms of Businesses

Throughout this book, the focus is on business finance—that is, the prac-
tice of accounting and financial management within business organizations.
There are three primary legal forms of business organization: proprietorship,
partnership, and corporation. In addition, there are several hybrid forms.
Because most health services managers work for corporations, and because
not-for-profit businesses are organized as corporations, this form of organiza-
tion is emphasized. However, some medical practices are organized as propri-
etorships, and partnerships and hybrid forms are common in group practices
and joint ventures, so health services managers must be familiar with all forms
of business organization.

Proprietorships
A proprietorship, sometimes called a sole proprietorship, is a business owned
by one individual. Going into business as a proprietor is easy—the owner
simply begins business operations. However, most cities require even the
smallest businesses to be licensed, and state licensure is required for most
healthcare professionals.

Partnerships
A partnership is formed when two or more people associate to conduct a
business that is not incorporated. Partnerships may operate under different
degrees of formality, ranging from informal oral understandings to formal
agreements filed with the state in which the partnership does business. Both
the proprietorship and partnership forms of organization are easily and inex-
pensively formed, are subject to few government regulations, and pay no
corporate income taxes. All earnings of the business, whether reinvested in
the business or withdrawn by the owner(s), are taxed as personal income to
the proprietor or partner.

Proprietorships and partnerships have several disadvantages, including
the following:

• Selling their interest in the business is difficult for the owners.
• The owners have unlimited personal liability for the debts of the

business, which can result in losses greater than the amount invested in
the business. In a proprietorship, unlimited liability means that the owner
is personally responsible for the debts of the business. In a partnership,
it means that if any partner is unable to meet his or her obligation in
the event of bankruptcy, the remaining partners are responsible for the
unsatisfied claims and must draw on their personal assets if necessary.

proprietorship
A simple form of
business owned by
a single individual;
also called sole
proprietorship.

partnership
A nonincorporated
business entity
that is created
by two or more
individuals.

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G apenski ’s Healthcare F inance16

• The life of the business is limited to the life of the owners.
• It is difficult for proprietorships and partnerships to raise large amounts

of capital. This is generally not a problem when the business is very
small or when the owners are very wealthy; however, the difficulty of
attracting capital becomes a real handicap if the business needs to grow
substantially to take advantage of market opportunities.

Corporations
A corporation is a legal entity that is separate and distinct from its owners
and managers. The creation of a separate business entity gives these primary
advantages:

• A corporation has an unlimited life and can continue in existence after
its original owners and managers have died or left the company.

• It is easy to transfer ownership in a corporation because ownership is
divided into shares of stock that can be sold.

• The owners of a corporation have limited liability.

To illustrate limited liability, suppose that an individual made an
investment of $10,000 in a partnership that subsequently went bankrupt,
owing $100,000. Because the partners are liable for the debts of the partner-
ship, that partner could be assessed for a share of the partnership’s debt in
addition to the loss of his or her initial $10,000 contribution. In fact, if the
other partners were unable to pay their shares of the indebtedness, one part-
ner would be held liable for the entire $100,000. However, if the $10,000
had been invested in a corporation that went bankrupt, the potential loss for
the investor would be limited to the $10,000 initial investment. (However,
in the case of small, financially weak corporations, the limited liability feature
of ownership is often fictitious because bankers and other lenders will require
personal guarantees from the stockholders.) Because of these three factors—
unlimited life, ease of ownership transfer, and limited liability—corporations
can more easily raise money in the financial markets than can sole proprietor-
ships or partnerships.

The corporate form of organization has two primary disadvantages.
First, corporate earnings of taxable entities are subject to double taxation—
once at the corporate level and then again at the personal level. Second, set-
ting up a corporation, and then filing the required periodic state and federal
reports, is more costly and time-consuming than what is required to establish
a proprietorship or partnership.

Setting up a corporation requires that the founders, or their attor-
ney, prepare a charter and a set of bylaws. Today, attorneys have standard

corporation
A legal business
entity that is
separate and
distinct from
its owners (or
community) and
managers.

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Chapter 1 : Healthcare F inance Basics 17

templates for charters and bylaws, so they can set up a “no-frills” corporation
with modest effort. In addition, several companies offer online services that
help with the incorporation process. Still, setting up a corporation remains
relatively difficult compared with a proprietorship or partnership, and it is
even more difficult if the corporation has nonstandard features, such as mul-
tiple classes of stock.

Hybrid Forms of Organization
Although the three basic forms of organization—proprietorship, partnership,
and corporation—historically have dominated the business scene, several
hybrid forms of organization have become quite popular in recent years.

In general, the hybrid forms are designed to limit owners’ liability
without having to fully incorporate. For example, in a limited liability part-
nership (LLP), the partners have joint liability for all actions of the partner-
ship, including personal injuries and indebtedness. However, all partners
enjoy limited liability regarding professional malpractice because partners
are only liable for their own individual malpractice actions, not those of the
other partners. In spite of limited malpractice liability, the partners are jointly
liable for the partnership’s debts. Other hybrid forms of organization include
limited liability companies (LLCs), professional corporations (PCs), and pro-
fessional associations (PAs).

1. What are the three primary forms of business organization, and
how do they differ?

2. What is the purpose of hybrid forms of business organization?

SELF-TEST
QUESTIONS

Corporate Ownership

In the previous section, we discussed the different legal forms of businesses.
Now, we turn our attention to the two ownership forms of corporations:
for-profit and not-for-profit. Unlike other sectors in the economy, not-
for-profit corporations play a major role in the healthcare sector, especially
among providers. For example, about 56 percent of the community hos-
pitals in the United States are private, not-for-profit hospitals. Only 25
percent of all community hospitals are investor owned; the remaining 19
percent are government hospitals.4 Furthermore, not-for-profit ownership is
common in the nursing home, home health care, hospice, and health insur-
ance industries.

limited liability
partnership (LLP)
A partnership form
of organization
that limits the
professional
(malpractice)
liability of its
partners.

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G apenski ’s Healthcare F inance18

Investor-Owned Corporations
When you think of a corporation, an investor-owned, or for-profit, cor-
poration likely comes to mind. For example, Ford (www.ford.com), IBM
(www.ibm.com), and Microsoft (www.microsoft.com) are investor-owned
corporations. In health services, corporations such as HCA Healthcare
(https://hcahealthcare.com) and Community Health Systems (www.chs.
net) are examples of large for-profit hospital systems; Kindred Health-
care (www.kindredhealthcare.com) and Brookdale Senior Living (www.
brookdale. com) are examples of long-term care providers; Select Medical
(www.select medical .com) and Encompass Health (www.encompasshealth.
com) offer rehabilitation services; and MEDNAX (www.mednax.com) offers
pediatric services. Individuals become owners of for-profit corporations by
buying shares of common stock in the company. The stockholders (also called
shareholders) are the owners of investor-owned corporations. As owners, they
have two basic rights:

• The right of control. Common stockholders have the right to vote
for the corporation’s board of directors, which oversees the management
of the company. Each year, a company’s stockholders receive a proxy
ballot, which they use to vote for directors and to vote on other
issues that are proposed by management or stockholders. In this way,
stockholders exercise control over the corporation. In the voting
process, stockholders cast one vote for each common share held.

• A claim on the residual earnings of the firm. A corporation sells
products or services and realizes revenues from the sales. To produce
these revenues, the corporation must incur expenses for materials,
labor, insurance, debt capital, and so on. Any excess of revenues
over expenses—the residual earnings—belongs to the shareholders
of the business. Often, a portion of these earnings is paid out in
the form of dividends, which are cash payments to stockholders, or
stock repurchases, in which the company buys back shares held by
stockholders. However, management typically elects to reinvest some
(or all) of the residual earnings in the business, which presumably will
produce even higher payouts to stockholders in the future.

Compared with not-for-profit corporations (discussed next), three
key features make investor-owned corporations different. First, the owners
(stockholders) of the corporation are well defined and exercise control of the
business by voting for directors. Second, the residual earnings of the business
belong to the owners, so management is responsible only to the stockhold-
ers for the profitability of the firm. Finally, investor-owned corporations are
subject to various forms of taxation at the local, state, and federal levels.

investor-owned
(for-profit)
corporation
A corporation
that is owned by
shareholders who
furnish capital and
expect to earn a
return on their
investment.

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Chapter 1 : Healthcare F inance Basics 19

Not-for-Profit Corporations
If an organization meets a set of stringent requirements, it can qualify for
incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt
corporations are sometimes called nonprofit corporations. Because nonprofit
businesses (as opposed to pure charities such as United Way) need profits to
sustain operations, and because it is hard to explain why nonprofit corpora-
tions should earn profits, the term not-for-profit better describes such health
services corporations. Examples of not-for-profit health services corporations
include Kaiser Permanente (https://healthy.kaiserpermanente.org), Catholic
Health Initiatives (www.catholichealthinitiatives.org), and the Mayo Clinic
Health System (www.mayoclinic.org).

Tax-exempt status is granted to corporations that meet the tax defini-
tion of a charitable organization as defined by Internal Revenue Service (IRS)
tax code section 501(c)(3) or 501(c)(4). Hence, such corporations are also
known as 501(c)(3) or 501(c)(4) corporations. The tax code defines a charita-
ble organization as “any corporation, community chest, fund, or foundation
that is organized and operated exclusively for religious, charitable, scientific,
public safety, literary, or educational purposes.” Because the promotion of
health is commonly considered a charitable activity, a corporation that pro-
vides healthcare services can qualify for tax-exempt status, provided that it
meets other requirements.

In addition to the charitable purpose, a not-for-profit corporation
must be organized and run so that it operates exclusively for the public,
rather than private, interest. Thus, no profits can be used for private gain,
and no direct political activity can be conducted. Also, if the corporation is
liquidated or sold to an investor-owned business, the proceeds from the liqui-
dation or sale must be used for charitable purposes. Because individuals can-
not benefit from the profits of not-for-profit corporations, such organizations
cannot pay dividends. However, the prohibition of private gain from profits
does not prevent parties, such as managers and physicians, from benefiting
through salaries, perquisites, contracts, and so on.

Not-for-profit corporations differ significantly from investor-owned
corporations. Because not-for-profit firms have no shareholders, no single
body of individuals has ownership rights to the firm’s residual earnings or
exercises control of the firm. Rather, control is exercised by a board of trustees
that is not constrained by outside oversight, as is the board of directors of
a for-profit corporation, which must answer to stockholders. Also, not-for-
profit corporations are generally exempt from taxation, including both prop-
erty and income taxes, and have the right to issue tax-exempt debt (municipal
bonds). Finally, individual contributions to not-for-profit organizations can
be deducted from taxable income by the donor, so not-for-profit firms have
access to tax-subsidized contribution capital.

tax-exempt
(not-for-profit)
corporation
A corporation that
has a charitable
purpose, is tax
exempt, and has
no owners; also
called nonprofit
corporation.

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G apenski ’s Healthcare F inance20

For-profit corporations must file annual income tax returns with the
IRS. The equivalent filing for not-for-profit corporations is IRS Form 990,
titled “Return of Organization Exempt from Income Tax.” Its purpose is to
provide both the IRS and the public with financial information about not-for-
profit organizations, and it is often the only source of such information. It is
also used by government agencies to prevent organizations from abusing their
tax-exempt status. Form 990 requires significant disclosures related to gover-
nance and boards of trustees. In addition, hospitals are required to file Sched-
ule H to Form 990, which includes financial information on the amount and
type of community benefit (primarily charity care) provided, bad debt losses,
Medicaid patients, and collection practices. IRS regulations require not-for-
profit organizations to provide copies of their three most recent Form 990s to
anyone who requests them, whether in person or by mail, fax, or email. Form
990s are also available to the public through several online services.

The financial problems facing most federal, state, and local govern-
ments have prompted politicians to take a closer look at the tax subsidies pro-
vided to not-for-profit hospitals. The Patient Protection and Affordable Care
Act (ACA) of 2010 added four requirements that must be met for hospitals
to maintain their tax-exempt status: (1) conducting a community health needs

assessment every three years and develop-
ing plans for implementation; (2) establish-
ing a written financial assistance policy; (3)
charging patients who qualify for financial
assistance amounts similar to what insured
patients are charged; and (4) not engag-
ing in aggressive collection efforts before
making an effort to determine whether a
patient is eligible for financial assistance.5

Likewise, officials in several states
have proposed or enacted legislation man-
dating the minimum amount of charity
care to be provided by not-for-profit hospi-
tals and the types of billing and collections
procedures that can be applied to the unin-
sured.6 For example, Texas has established
minimum requirements for charity care
that hold not-for-profit hospitals account-
able to the public for the tax exemptions
they receive. The Texas law specifies four
tests, and each hospital must meet at least
one of them. The test that most hospitals
use to comply with the law requires that at

Form 990
A form filed by
not-for-profit
organizations
with the Internal
Revenue Service
that reports
on governance
and charitable
activities.

Schedule H
An attachment
to Form 990 filed
by not-for-profit
hospitals that
gives additional
information
on charitable
activities.

For Your Consideration
Making Not-for-Profit Hospitals Do Good

Many people have criticized not-for-profit hos-
pitals for not “earning” their charitable exemp-
tions. In a 2010 court ruling, the Illinois Supreme
Court concluded that Provena Covenant hospital,
located in Urbana, Illinois, was not a charitable
institution for property tax purposes. The court’s
opinion reasoned that the primary use of the
hospital property was to provide medical services
for a fee, whereas charity means providing a gift
to the community. The opinion further pointed
out that (1) the charity care being provided was
subsidized by payments from other patients; (2)
many patients granted partial charity care still
paid enough to cover costs; and (3) the hospital’s
community benefit activities, such as a residency
program and an education program for emergency
responders, also benefited the hospital and thus
were not truly gifts to the community. Thus, the
hospital property was not in charitable use.

(continued)

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Chapter 1 : Healthcare F inance Basics 21

least 4 percent of net patient service rev-
enue be spent on charity care.

Finally, municipalities in several
states have attacked the property tax
exemptions of not-for-profit hospitals that
have “neglected” their charitable mis-
sions. For example, in 2015, a tax court in
New Jersey canceled a not-for-profit hos-
pital’s property tax exemption because it
was found to have substantial “for-profit”
elements and characteristics that made it
ineligible for the exemption.7 According
to one estimate, if all not-for-profit hos-
pitals had to pay taxes comparable to their
investor-owned counterparts, local, state,
and federal governments would receive an
additional $17.9 billion in tax revenues.8
This estimate explains why tax authorities
in many jurisdictions are pursuing not-
for-profit hospitals as a source of revenue.

The inherent differences between investor-owned and not-for-profit
organizations have profound implications for many elements of healthcare
financial management, including organizational goals, financing decisions
(i.e., the choice between debt and equity financing and the types of securities
issued), and capital investment decisions. Ownership’s effect on the applica-
tion of healthcare financial management theory and concepts is addressed
throughout the text.

1. What are the major differences between investor-owned and not-
for-profit corporations?

2. What types of requirements have been placed on not-for-profit
hospitals to ensure that they meet their charitable mission?

3. What are the purpose and content of IRS Form 990?

SELF-TEST
QUESTIONS

Organizational Goals

Healthcare finance is not practiced in a vacuum; it is practiced with some
objective in mind. Finance goals within an organization clearly must be con-
sistent with, as well as supportive of, the overall goals of the business. Thus,

Most not-for-profit hospitals today are
primarily supported by payments for ser-
vices rather than by charitable contributions.
Under the opinion’s reasoning, the property
tax exemption may well be hard to maintain.
However, a partial dissent by two justices sug-
gests that this case is not the end of the story.
The dissent argues that the plurality opinion
impinges on the legislative function of setting
specific standards for tax exemption, and the
issue should be settled by legislative action
rather than by courts.

What do you think? Should not-for-profit
hospitals lose their property tax or income tax
exemptions? Should legislatures set standards
that hospitals must meet to maintain their tax-
exempt status? If so, how might such standards
be specified?

(continued from previous page)

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G apenski ’s Healthcare F inance22

by discussing organizational goals, a framework for financial decision-making
within health services organizations can be established.

Small Businesses
In a small business, regardless of its legal form, the owners generally are also
its managers. In theory, the business can be operated for the exclusive benefit
of the owners. If the owners want to work very hard to get rich, they can.
On the other hand, if every Wednesday is devoted to golf, no outside owner
is hurt by such actions. (Of course, the business still has to satisfy its custom-
ers or it will not survive.) It is in large, publicly held corporations, in which
owners and managers are separate parties, that organizational goals become
important to the practice of finance.

Publicly Held Corporations
From a finance perspective, the primary goal of large investor-owned corpo-
rations is generally assumed to be shareholder wealth maximization, which
translates to stock price maximization. Investor-owned corporations do,
of course, have other goals. Managers, who make the actual decisions, are
interested in their own personal welfare, in their employees’ welfare, and in
the good of the community and society at large. Still, the goal of stock price
maximization is a reasonable operating objective on which to build financial
decision-making rules.

Not-for-Profit Corporations
Corporations consist of a number of classes of stakeholders, which include
all parties that have an interest, usually of a financial nature, in the orga-
nization. For example, a not-for-profit hospital’s stakeholders include the
board of trustees, managers, employees, physician staff, creditors, suppliers,
patients, and even potential patients, which may include the entire com-
munity. An investor-owned hospital has the same set of stakeholders, plus
stockholders, who dictate the goal of shareholder wealth maximization.
While managers of investor-owned companies have to please primarily one
class of stakeholders—the shareholders—to keep their jobs, managers of
not-for-profit firms face a different situation. They have to try to please
all of the organization’s stakeholders because no single well-defined group
exercises control.

Many people argue that managers of not-for-profit corporations do not
have to please anyone at all because they tend to lead the boards of trustees
that are supposed to exercise oversight. Others argue that managers of not-for-
profit corporations have to please all of the business’s stakeholders to a greater
or lesser extent because all are necessary to the successful performance of the
business. Of course, even managers of investor-owned corporations should not

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Chapter 1 : Healthcare F inance Basics 23

attempt to enhance shareholder wealth by
treating other stakeholders unfairly, because
such actions ultimately will be detrimental
to shareholders.

Typically, not-for-profit corpora-
tions state their goals in terms of a mission
statement. For example, here is the current
mission statement of Riverside Hospital, a
450-bed, not-for-profit acute care hospital:

To care for others as we would care for those

we love—to enhance their well-being and

improve their health.

Although this mission statement provides
Riverside’s managers and employees with
a framework for developing specific goals
and objectives, it does not provide much
insight into the goal of the hospital’s
finance function. For Riverside to accom-
plish its mission, its managers have identi-
fied the following five financial goals:

1. The hospital must maintain its
financial viability.

2. The hospital must generate sufficient
profits to continue to provide the
current range of healthcare services
to the community. This means that current buildings and equipment
must be replaced as they become obsolete.

3. The hospital must generate sufficient profits to invest in new medical
technologies and services as they are developed and needed.

4. Although the hospital has an aggressive philanthropy program in place,
it does not want to rely on this program or government grants to fund
its operations.

5. The hospital will strive to provide high-quality services to the
community as inexpensively as possible, given the financial
requirements.

In effect, Riverside’s managers are saying that to achieve the hospital’s
commitment to excellence as stated in its mission, it must remain financially

For Your Consideration
Does the Finance Function Differ
Among Providers?

Readers of this book understand the difference
between for-profit and not-for-profit providers.
Not-for-profit providers have a charitable mis-
sion, whereas for-profits are in business to make
money for owners. Furthermore, all not-for-profit
earnings must be reinvested in the enterprise,
while some (or all) profits of for-profit health
services businesses may be returned to owners
in the form of dividends or stock repurchases.
Although many studies have tried to assess which
type of ownership is better for patients, no con-
sensus has been reached.

But what about the finance function? That
is, what about the day-to-day activities of opera-
tional managers and the finance staff? Are these
appreciably different at not-for-profit providers
than at for-profit providers? What about different
types of providers—say, medical group practices
versus hospitals?

What do you think? Is the finance function at
not-for-profit providers appreciably different from
that at for-profit providers, or is there an appre-
ciable difference between types of providers? If
there are differences, what are they?

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G apenski ’s Healthcare F inance24

strong and profitable. Financially weak organizations cannot continue to
accomplish their stated missions over the long run.

Riverside’s five financial goals are probably not much different
from the financial goals of Jeffersonville Health System (JHS), a for-profit
competitor. Of course, JHS has to worry about providing a return to its
shareholders, and it receives only a very small amount of contributions and
grants. However, to maximize shareholder wealth, JHS also must maintain its
financial viability and have the financial resources necessary to offer new ser-
vices and technologies. Furthermore, competition in the market for hospital
services does not permit JHS to charge appreciably more for services than its
not-for-profit competitors.

1. What is the difference in goals between investor-owned and not-
for-profit businesses?

2. Briefly describe the differences in key stakeholders between
investor-owned and not-for-profit businesses.

SELF-TEST
QUESTIONS

Healthcare Reform and Finance

The Affordable Care Act has been called the most significant healthcare leg-
islation since Medicare and Medicaid were enacted in 1965. The ACA, which
became law on March 23, 2010, was designed to provide all US citizens and
legal residents with access to affordable health insurance, reduce healthcare
costs, and improve care and quality. The legislation put in place comprehen-
sive health insurance exchanges to expand coverage, enacted provisions to
hold insurance companies accountable for product cost and quality, required
that everyone buy insurance through an individual mandate (this provision
was repealed in 2017 as part of the Tax Cuts and Jobs Act), and offered sub-
sidies to low-income individuals. All of these components of the ACA were
intended to transform the US healthcare system and make it more affordable
and sustainable.

The ACA had numerous aims. However, the central goal was to
expand healthcare coverage through shared responsibility among govern-
ment, individuals, and employers.

Since the ACA’s passage, several congressional efforts have been
made to repeal and replace the law; however, none has been passed. While
the future of healthcare reform is uncertain, major provisions of the ACA
remained in effect in 2020. The major implications of healthcare reform for

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Chapter 1 : Healthcare F inance Basics 25

health insurance and provider payments are addressed in chapters 2 and 3,
respectively. The major implications of healthcare reform for the institutional
setting and the delivery of healthcare services are discussed in the next sec-
tion of this chapter.

Key Trends Following the Affordable Care Act

Sector Consolidation
Since its passage, the ACA has driven the consolidation of healthcare organi-
zations. It has accelerated health systems’ acquisition of hospitals and hospi-
tals’ acquisition of physician practices—a trend that is likely to continue for
many years. As a result of their greater focus on clinical integration, quality of
care, and changing reimbursement methodologies, healthcare organizations
are now seeking to restructure healthcare delivery to operate more efficiently
and to improve coordination between patients and providers. Healthcare
organizations are also looking to gain a competitive advantage by combining
assets, staff, and resources.

Consolidation not only provides organizations with access to capital,
economies of scale, negotiating power with payers, and market share, but
also it may lead to improvements in patient care by making it easier to share
patient information, adhere to clinical practice guidelines (thus reducing
variations in care), and access high-quality specialist physicians. There is,
however, a notable downside to consolidation: increases in prices as health-
care organizations gain greater market share and negotiating power.

Population Health
The ACA is moving providers toward the population health management
approach to care provision. The goal of population health management is to
shift the focus of healthcare from treating illness to maintaining or improving
health. The idea is to prevent costly illnesses when possible and hence avoid
unnecessary care. This approach is supported by reimbursement models such
as capitation, payment bundling, and shared savings (discussed in chapter 2).
Instead of providing only preventive and chronic care when patients seek out
healthcare for acute problems, healthcare practices that adopt the population
health management approach track and monitor the health status of their
entire patient population. Doing so requires greater use of health informa-
tion technology (IT). Key to the success of population health management
are greater awareness of the health status of the population and proactive
intervention to reduce the use of provider resources and achieve the best
population outcomes.

population health
management
The concept that
the health of all
individuals is
improved when
the health of the
entire population
is improved.

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G apenski ’s Healthcare F inance26

Social Determinants of Health
In response to increasing incentives to manage healthcare utilization and
costs, health systems, government payers, and insurers are taking steps to
address the social determinants of health. Scholars and healthcare provid-
ers increasingly are recognizing that social, economic, and environmental
factors such as housing, education, income, and food security have a power-
ful influence on health outside the healthcare system. Examples of initiatives
to address the social determinants of health include screening patients or
populations for social needs (e.g., healthy food, housing) and then connect-
ing individuals with resources (e.g., food pantries, information and referral
services) in sectors outside healthcare. This goal is consistent with the popu-
lation health management approach, which focuses on preventing costly ill-
nesses, improving health, and reducing health inequities.

Clinical Integration
A fundamental component of achieving the goals of healthcare reform is
clinical integration. Clinical integration aims to coordinate patient care across
conditions, providers, settings, and time to achieve care that is safe, timely,
effective, efficient, and patient focused. New payment models and advances
in health IT systems are used to facilitate the transition to the clinical integra-
tion model and to manage the continuum of care for patients. Provider pay-
ments are tied to results for quality, access, and efficiency with the objective
of better coordination between hospitals and physicians.

Health IT supports clinical integration by capturing patient informa-
tion and making it accessible to authorized providers at the point of care.
Complete patient information facilitates optimal treatment strategies and
reduces the chance of medication errors and conflicting treatment plans.
However, the sharing of patient data requires that policies and procedures
be in place to protect patient privacy and to guarantee the security of data
transferred among patients, caregivers, and organizations.

Technology
Technology has a major impact on the delivery and financial management
of healthcare, as shown by the adoption of electronic health record systems
starting in the 2000s; however, healthcare as a sector has been slow to adopt
new technology because of privacy and safety concerns. A new technology,
blockchain, has the potential to drastically change the way healthcare pro-
viders protect their data and communicate with each other. Blockchain is
a system of securing data by linking pieces of data together in chains; thus,
a change to one piece of data will update the rest of the chain. While this
technology has the potential to revolutionize the sharing of electronic health
data, there are still some concerns about ensuring patient privacy.

social
determinants of
health
Social, economic,
and environmental
conditions in the
places where
people are born,
live, grow, learn,
work, and play
that affect health.

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Chapter 1 : Healthcare F inance Basics 27

Electronic health data are still hard to share among providers. How-
ever, the increasing emphases on collaboration among clinicians and on
quality patient care are spurring healthcare organizations to invest in inte-
grated health IT systems to collect large quantities of patient and provider
data (so-called big data). Data analytic systems are capable of analyzing
large amounts of patient data to better understand clinical processes and to
identify problems and opportunities for improvement in the provision of
healthcare services. New, complex IT systems and applications of artificial
intelligence will facilitate the analysis of care coordination, patient safety, and
healthcare utilization.

Staffing Shortages
Healthcare reform has increased the number of patients who can access
the healthcare system. As a result, healthcare organizations are seeing an
influx of formerly uninsured patients who are now seeking care because they
have insurance or better coverage. As a result, the demand for healthcare
professionals—especially primary care physicians, nurse practitioners, and
physician assistants—has increased.

Healthcare reform is also driving changes in hospital staffing by
emphasizing prevention and value-based care, creating demand for primary
care providers, emergency physicians, clinical pharmacists, social workers
and care coordinators, and health IT and data specialists. Several strategies
may increase the supply and distribution of health professionals (including
primary care physicians): scholarships, flexible loan repayment programs,
and debt forgiveness have been identified as ways to increase the number of
providers and attract them to underserved areas. However, many healthcare
organizations likely will face great competition for some healthcare staff.

Key Programs of the Affordable Care Act

Accountable Care Organizations
Accountable care organizations (ACOs), a cornerstone of healthcare
reform, integrate local physicians with other members of the healthcare com-
munity and reward them for controlling costs and improving quality. While
ACOs are not radically different from other attempts to improve the delivery
of healthcare services, they are unique in the flexibility of their structures
and payment methodologies and in their ability to assume risk while meeting
quality targets. Similar to some managed care organizations and integrated
healthcare systems such as the Mayo Clinic, ACOs are responsible for the
health outcomes of a specific population and tasked with collaboratively
improving care to reach cost and quality targets set by Medicare. To help

accountable care
organization (ACO)
A network of
healthcare
providers joined
together for
the purpose of
increasing patient
service quality and
reducing costs.

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G apenski ’s Healthcare F inance28

achieve cost control and quality goals, ACOs can distribute bonuses when
targets are met and impose penalties when targets are missed.

One feature of healthcare reform is a shared savings program in which
Medicare pays a fixed (global) payment to ACOs that covers the full cost
of care for an entire population. This program establishes cost and quality
targets. Any cost savings (i.e., costs that are below the target) are shared
between Medicare and the ACO, as long as the ACO also meets its quality
targets. If an ACO is unable to save money, it could be liable for the costs of
the investments made to improve care; it also may have to pay a penalty if it
does not meet performance and savings benchmarks.

To be effective, an ACO should include, at a minimum, primary care
physicians, specialists, and a hospital, although some ACOs are being estab-
lished solely by physician groups.

An ACO can take many forms, such as the following:

• An integrated delivery system that has common ownership of hospitals
and physician practices and has electronic health records, team-based
care, and resources to support cost-effective care

• A multispecialty group practice that has strong affiliations with
hospitals and contracts with multiple health plans

• A physician–hospital organization that is a subset of a hospital’s medical
staff and functions, such as a multispecialty group practice

• An independent practice association comprising individual physician
practices that come together to contract with health plans

• A virtual physician organization that sometimes includes physicians in
rural areas

ACOs should have managerial systems in place to administer pay-
ments, set benchmarks, measure performance, and distribute shared savings.
A variety of federal, regional, state, and academic hospital initiatives are
investigating how best to implement ACOs. Although the concept shows
potential, many legal and managerial hurdles must be overcome for ACOs to
live up to their promise.

Medical Homes
A medical home (or patient-centered medical home) is a team-based model
of care that is led by a personal physician who provides continuous and
coordinated care throughout a patient’s lifetime with the goal of maxi-
mizing health outcomes. The medical home is responsible for meeting all
of a patient’s healthcare needs or appropriately arranging care with other
qualified professionals. This includes the provision of preventive services,

medical home
A team-based
model of care
led by a personal
physician
who provides
continuous and
coordinated care
throughout a
patient’s lifetime
with a goal of
maximizing health
outcomes; also
called patient-
centered medical
home.

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Chapter 1 : Healthcare F inance Basics 29

treatment of acute and chronic illnesses, and assistance with end-of-life care.
It is a model of practice in which a team of healthcare professionals, coordi-
nated by a personal physician, works collaboratively to ensure coordinated
and integrated care, patient access and communication, quality, and safety.
The medical home model is independent of the ACO concept, but most
ACOs provide an organizational setting that facilitates implementation of
the model.

Supporters of the medical home model argue that it allows better access
to healthcare, increases patient satisfaction, and improves health. The Agency
for Healthcare Research and Quality defines a medical home as a model of
primary care that encompasses the following functions and attributes:9

• Comprehensive care. The medical home includes a team of providers
that are responsible for meeting a majority of the patients’ physical and
mental healthcare needs.

• Patient-centered. The medical home partners with patients and
families to help patients actively engage in care decisions and manage
their care.

• Coordinated care. The medical home coordinates care across
specialists, hospitals, home health agencies, nursing homes, hospices,
and community services.

• Accessible services. Medical care and information are available at all
times through open scheduling, expanded hours of service, and new
and innovative communications technologies.

• Quality and safety. Quality and patient safety are ensured by a care
planning process, evidence-based medicine, clinical decision support
tools, performance measurement, active participation of patients in
decision-making, use of IT, and quality improvement activities.

• Payment-for-value methodologies. Payment methodologies must
recognize the added value provided to patients. Payments should reflect
the value of work that falls outside of face-to-face visits, support the
adoption and use of health IT for quality improvement, and recognize
differences among the patient populations treated within the practice.

1. What is the primary purpose of healthcare reform?
2. What is an accountable care organization (ACO), and what is it

designed to accomplish?
3. What is the medical home model, and what is its purpose?

SELF-TEST
QUESTIONS

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G apenski ’s Healthcare F inance30

Key Concepts
This chapter provides an introduction to healthcare finance. The key
concepts of this chapter are as follows:

• The term healthcare finance, as it is used in this book, refers to
the accounting and financial management principles and practices
used within health services organizations to ensure the financial
well-being of the enterprise.

• A business maintains its financial viability by selling goods or
services, whereas a pure charity relies solely on contributions.

• The primary role of finance in health services organizations, as
in all businesses, is to plan for, acquire, and use resources to
maximize the efficiency and value of the organization.

• Finance activities generally include (1) planning and budgeting,
(2) financial reporting, (3) capital investment decisions, (4)
financing decisions, (5) revenue cycle and current accounts
management, (6) contract management, and (7) financial risk
management. These activities can be summarized by the four Cs:
costs, cash, capital, and control.

• The size and structure of the finance department within a
health services organization depend on the type of provider
and its size. The finance department within a larger provider
organization generally consists of a chief financial officer (CFO),
who typically reports directly to the chief executive officer (CEO)
and is responsible for all finance activities within the organization.
Reporting to the CFO are the comptroller, who is responsible
for accounting and reporting activities, and the treasurer, who is
responsible for the acquisition and management of capital (funds).

• In larger organizations, the comptroller and treasurer direct
managers who have responsibility for specific functions, such as
the patient accounts manager, who reports to the comptroller,
and the cash manager, who reports to the treasurer.

• In small health services organizations, the finance responsibilities
are combined and assigned to one individual, often called the
business (practice) manager.

• All business decisions have financial implications, so all
managers—whether they are in finance or not—must know
enough about finance to incorporate those implications into their
own specialized decision-making processes.

(continued)

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Chapter 1 : Healthcare F inance Basics 31

• Recent surveys of health services executives confirm that
healthcare managers regard financial concerns as the most
important issue they face.

• The three main forms of business organization are proprietorship,
partnership, and corporation. Although each form of
organization has its own unique advantages and disadvantages,
most large organizations, and all not-for-profit entities, are
organized as corporations.

• Investor-owned corporations have stockholders who are the
owners of the corporation. As owners, stockholders have claim
on the residual earnings of the corporation. Investor-owned
corporations are fully taxable.

• Charitable organizations that meet certain criteria can be
organized as not-for-profit corporations. Rather than having
a well-defined set of owners, such organizations have a
large number of stakeholders who have an interest in the
organization. Not-for-profit corporations do not pay taxes, they
can accept tax-deductible contributions, and they can issue tax-
exempt debt.

• In lieu of tax filings, not-for-profit corporations must file IRS
Form 990, which reports on an organization’s governance
structure and community benefit services, with the Internal
Revenue Service.

• From a financial management perspective, the primary goal of
investor-owned corporations is shareholder wealth maximization,
which translates into stock price maximization. For not-for-
profit corporations, a reasonable goal for financial management
is to ensure that the organization can fulfill its mission, which
translates to maintaining financial viability.

• Healthcare reform—such as the Affordable Care Act (ACA),
federal legislation that was signed into law in 2010—is having a
significant impact on health insurers and providers.

• Accountable care organizations (ACOs) integrate local physicians
with other members of the healthcare community and reward
them for controlling costs and improving quality.

• A medical home (or patient-centered medical home) is a team-
based model of care led by a personal physician who provides
continuous and coordinated care throughout a patient’s lifetime
to maximize health outcomes.

(continued from previous page)

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G apenski ’s Healthcare F inance32

In chapter 2, we continue the discussion of the healthcare environment,
with an emphasis on health insurance and reimbursement methodologies.

Questions

1.1. Briefly describe the purpose and organization of this book and the
learning tools embedded in each chapter.

1.2. a. What are some of the subsectors that make up the healthcare
sector?

b. What is meant by the term healthcare finance as it is used in this
book?

c. What are the two broad areas of healthcare finance?
d. Why is it necessary to have a book on healthcare finance as

opposed to a generic finance book?
1.3. What is the difference between a business and a pure charity?
1.4. a. Briefly discuss the role of finance in the health services sector.

b. Has this role increased or decreased in importance in recent
years?

1.5. What is the structure of the finance department within health
services organizations?

1.6. a. (Hint: The material reviewed in this question is covered in the
chapter 1 supplement online.) Briefly describe the following
health services settings:
• Hospitals
• Ambulatory care
• Home health care
• Long-term care
• Integrated delivery systems

b. What are the benefits attributed to integrated delivery systems?
1.7. What are the major current concerns of healthcare managers?
1.8. What are the three primary forms of business organization?

Describe their advantages and disadvantages.
1.9. What are the primary differences between investor-owned and not-

for-profit corporations?
1.10. a. What is the primary goal of investor-owned corporations?

b. What is the primary goal of most not-for-profit healthcare
corporations?

c. Are there substantial differences between the finance goals of
investor-owned and not-for-profit corporations? Explain.

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Chapter 1 : Healthcare F inance Basics 33

1.11. Briefly describe the main provisions of the Affordable Care Act and
its implications for the practice of healthcare finance.

1.12. Describe the primary features of accountable care organizations and
medical homes. What benefits are attributed to them?

Notes

1. American College of Healthcare Executives. 2019. “Survey: Healthcare
Finance, Governmental Mandates, Personnel Shortages Cited by CEOs
as Top Issues Confronting Hospitals in 2018.” Published January
25. www.ache.org/about-ache/news-and-awards/news-releases/top
-issues-confronting-hospitals-in-2018.

2. Advisory Board. 2019. “We Asked 90 C-Suite Executives About Their
Biggest Concerns. Here’s What They Told Us.” Published June 13.
www.advisory.com/research/health-care-advisory-board/blogs/at
-the-helm/2019/06/c-suite.

3. Healthcare Finance Management Association. 2013. “HRMA’s
Executive Survey: Clinical Documentation Meets Financial
Performance.” Published November. www.hfma.org/content/dam
/hfma /document/research_reports/PDF/20158.pdf.

4. American Hospital Association. 2020. “Fast Facts on U.S. Hospitals,
2020.” Accessed January 13. www.aha.org/statistics/fast-facts -us
-hospitals.

5. James, J. 2016. “Nonprofit Hospitals’ Community Benefit
Requirements.” Health Policy Brief, Health Affairs. Published
February 25. www.healthaffairs.org/do/10.1377/hpb201 60225
.954803/full/healthpolicybrief_153.pdf.

6. Hilltop Institute. 2015. “Community Benefit State Law Profiles.”
Published January. www.hilltopinstitute.org/wp-content/uploads
/publications/CommunityBenefitStateLawProfiles-January2015.pdf.

7. Chiesa Shahinain & Giantomasi. 2015. “Tax Court Ruling Cancels
Property Tax Exemption for Non-Profit Hospital.” Published July.
www.csglaw.com/hospital-tax-exemption.

8. Rosenbaum, S., D. A. Kindig, J. Bao, M. K. Byrnes, and C.
O’Laughlin. 2015. “The Value of the Nonprofit Hospital Tax
Exemption Was $24.6 Billion in 2011.” Health Affairs 34 (7):
1225–33.

9. Agency for Healthcare Research and Quality, Patient-Centered Medical
Home Resource Center. 2020. “Defining the PCMH.” Accessed
January 13. https://pcmh.ahrq.gov/page/defining-pcmh.

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G apenski ’s Healthcare F inance34

Resources

For a general introduction to the healthcare system in the United States, see
Barton, P. L. 2010. Understanding the U.S. Health Services System. Chicago: Health

Administration Press.
Shi, L., and D. A. Singh. 2013. Essentials of the U.S. Health Care System. Burlington,

MA: Jones & Bartlett Learning.

For the latest information on events that affect health services organizations, see
Modern Healthcare, published weekly by Crain Communications Inc.: www
.crain.com/brands/modern-healthcare/.

For current information about the Affordable Care Act, see the Kaiser Family
Foundation: www.kff.org/.

For information about the patient-centered medical home model of care, see the
Agency for Healthcare Research and Quality’s Patient-Centered Medical Home
Resource Center: https://pcmh.ahrq.gov/page/defining-pcmh.

For discussion of the future of healthcare in the United States and other infor-
mation pertinent to this chapter, see
Bisognano, M. 2011. “Finance Is Key to Achieving Quality and Cost Goals.” Health-

care Financial Management 65 (4): 68–71.
French, M. T., J. Homer, G. Gumus, and L. Hickling. 2016. “Key Provisions of the

Patient Protection and Affordable Care Act (ACA): A Systematic Review and
Presentation of Early Research Findings.” Health Services Research 51 (5):
1735–71.

Hegwer, L. R., and N. Hut. 2019. “The Healthcare CFO of the Future: How
Finance Leaders Are Adapting to Relentless Change.” Healthcare Financial
Management. Published September 1. www.hfma.org/topics/hfm/2019
/september/the-healthcare-cfo-of-the-future.html.

Kim, C., D. Majka, and J. H. Sussman. 2011. “Modeling the Impact of Healthcare
Reform.” Healthcare Financial Management 65(1): 51–60.

Korenstein, D., K. Duan, M. J. Diaz, R. Ahn, and S. Keyhani. 2016. “Do Health
Care Delivery System Reforms Improve Value? The Jury Is Still Out.” Medi-
cal Care 54 (1): 55–66.

Lee, J. G., G. Dayal, and D. Fontaine. 2011. “Starting a Medical Home: Better
Health at Lower Cost.” Healthcare Financial Management 65 (6): 71–80.

Mulvany, C. 2011. “Medicare ACOs No Longer Mythical Creatures.” Healthcare
Financial Management 65 (6): 96–104.

Nguyen, J., and B. Choi. 2011. “Accountable Care: Are You Ready?” Healthcare
Financial Management 65 (8): 92–100.

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Chapter 1 : Healthcare F inance Basics 35

Rauh, S. S., E. B. Wadsworth, W. B. Weeks, and J. N. Weinstein. 2013. “The Savings
Illusion—Why Clinical Quality Improvement Fails to Deliver Bottom-Line
Results.” New England Journal of Medicine 365 (26): e48.

Smith, P. C., and K. Noe. 2012. “New Requirements for Hospitals to Maintain Tax-
Exempt Status.” Journal of Health Care Finance 38 (3): 16–21.

Song, P. H., S. D. Lee, J. A. Alexander, and E. E. Seiber. 2013. “Hospital Ownership
and Community Benefit: Looking Beyond Uncompensated Care.” Journal of
Healthcare Management 58 (2): 126–42.

For current information on how the internet affects health and the provision of
health services, see the Journal of Medical Internet Research: www.jmir.org.

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CHAPTER

71

3FINANCIAL ACCOUNTING BASICS, THE
INCOME STATEMENT, AND THE STATEMENT
OF CHANGES IN EQUITY

Learning Objectives
After studying this chapter, readers will be able to

• Name the primary financial statements that make up financial
reporting.

• Define the five account types used in financial accounting.
• Explain why financial statements are so important both to

managers and to outside parties.
• Describe the standard-setting process (operating procedures)

under which financial accounting information is created and
reported, as well as the underlying principles applied.

• Describe the components of the income statement—revenues,
expenses, and profitability—and the relationships within and
among these components.

• Explain the differences between operating income and net
income and between net income and cash flow.

• Describe the format and use of the statement of changes in equity.

Introduction

Financial accounting involves identifying, measuring, recording, and com-
municating in dollar terms the economic events and status of an organization.
This information is summarized and presented in a set of financial statements,
or just financials. Because these statements communicate important informa-
tion about an organization, financial accounting is often called “the language
of business.” Managers of health services organizations must understand the
basics of financial accounting because financial statements are the best way to
summarize a business’s financial status and performance.

financial
accounting
The field of
accounting that
focuses on the
measurement and
communication
of the economic
events and status
of an entire
organization.

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G apenski ’s Healthcare F inance72

Financial Statements
A full set of financial statements communicates information about an organi-
zation’s financial position, changes in its financial position, transactions with
owners, cash flows, and any additional information needed to interpret or
understand the information provided in the statements. A complete set of
financial statements includes five components: (1) balance sheet, (2) income
statement, (3) statement of changes in equity, (4) statement of cash flows,
and (5) notes. Each of these components provides a different kind of infor-
mation; certain individual statements may be of more interest to particular
users than others.

Often, the primary means of disseminating this information to outsid-
ers is the business’s annual report. It typically begins with a descriptive sec-
tion that discusses, in general terms, the organization’s operating results over
the past year as well as developments that are expected to affect future opera-
tions. The descriptive section is followed by the business’s financial statements.

Because the actual financial statements cannot possibly contain all rel-
evant information, additional information is provided in the notes section. For
health services organizations, these notes contain information on such topics as
accounting practices, the composition of long-term debt, pension plan status,
the amount of charity care provided, and the cost of malpractice insurance.

In addition to the body of the financial statements and the notes
section, organizations are often required to provide certain supplementary
information. Other supplementary information may be provided voluntarily
by the reporting organization. For example, a healthcare system may report
the revenues of its primary subsidiaries as supplementary data even though
its financial statements focus on the aggregate revenues of the entire system.
Because the notes and supplementary information sections contain a great
deal of information that is essential to a good understanding of the financial
statements, a thorough examination always considers the information con-
tained in these two sections.

The income statement and statement of changes in equity are dis-
cussed in more detail later in this chapter. The balance sheet and statement
of cash flows are covered in chapter 4. For now, it is enough to understand
that financial reporting entails a variety of components that together meet
the objective of communicating important information about an organiza-
tion to users.

The Building Blocks of Financial Accounting
The financial accounting model is built on five types of accounts that are
summarized in the financial statements: assets, liabilities, equity, revenues,
and expenses. Assets are the resources, or things of value, that are owned or
controlled by the business. Assets either possess (e.g., cash) or create (e.g.,
equipment) economic value for the organization.

annual report
A report issued
annually by an
organization to
its stakeholders
that contains
descriptive
information
and financial
statements for the
prior year.

asset
An item that either
possesses or
creates economic
value for an
organization.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 73

Liabilities are the fixed financial obligations of the organization
(e.g., debt). Liabilities represent claims on the assets of the organization by
creditors.

Equity is the “book value” of the ownership position in an organiza-
tion. It is the value of the assets as reported on an organization’s financial
statements that remains after subtracting the liabilities.

Revenues are inflows of assets, such as cash, that result from the
exchange of goods or services with customers. Because revenues increase the
assets of an organization without increasing liabilities, revenues add to the
organization’s equity.

Expenses are the costs incurred by an organization to produce rev-
enues. Because expenses represent the consumption of assets (e.g., cash) to
provide goods and services, expenses decrease the organization’s equity.

The relationships among the five account types, their presentation
in the financial statements of an organization, and their use in recording
economic activity are discussed throughout this chapter, as well as in chap-
ter 4 and the chapter 4 supplement. Before we begin, however, we provide
some background to help readers better understand financial accounting and
reporting.

1. What are the five components of a full set of financial statements?
2. Why are the notes and supplementary information sections

important parts of the financial statements?
3. What are the five account types used in financial accounting?

SELF-TEST
QUESTIONS

Historical Foundations of Financial Accounting

It is easy to think of financial statements merely as pieces of paper with
numbers written on them, rather than in terms of the economic events and
physical assets—such as land, buildings, and equipment—that the numbers
represent. If readers of financial statements understand how and why finan-
cial accounting began and how financial statements are used, they can better
understand what is happening within a business and why financial accounting
information is so important.

Thousands of years ago, individuals and families were self-contained.
They gathered their own food, made their own clothes, and built their own
shelters. Eventually, people began to specialize: Some individuals or families
became good at hunting, others at making spearheads, others at making
clothing, and so on. With specialization came trade, initially by bartering
one type of goods for another. At first, each producer worked alone, and

liability
A fixed financial
obligation of an
organization.

equity
Assets minus
liabilities; in other
words, the “book
value” of the
ownership position
of a business.

revenues
Inflows of assets
resulting from the
exchange of goods
or services with
customers.

expenses
The costs of doing
business; the dollar
value of resources
used to provide
goods or services.

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G apenski ’s Healthcare F inance74

trade was strictly local. Over time, some people set up production shops that
employed workers, simple forms of money were used, and trade expanded
beyond the local area. As these simple economies expanded, more formal
forms of money developed and a primitive form of banking emerged, as
wealthy merchants lent profits from their past dealings to enterprising shop
owners and traders who needed money to expand their operations.

When the first loans were made, lenders could physically inspect borrow-
ers’ assets and judge the likelihood of repayment. Eventually, lending became
much more complex. Industrial borrowers were developing large factories,
merchants were acquiring fleets of ships and wagons, and loans were being
made to finance business activities at distant locations. At that point, lend-
ers could no longer easily inspect the assets that backed their loans, and they
needed a practical way of summarizing the value of those assets. Also, some
loans were made on the basis of a share of the profits of the business, so a uni-
form, widely accepted method for documenting income was required. In addi-
tion, owners required reports to see how effectively their own enterprises were
being operated, and governments needed information to assess taxes. For all
these reasons, a need arose for financial statements, for accountants to prepare
the statements, and for auditors to verify the accuracy of the accountants’ work.

The economic systems of industrialized countries have grown enor-
mously since the early days of trade, and financial accounting has become
much more complex. However, the original reasons for creating financial
statements still apply: Bankers and other investors need accounting informa-
tion to make intelligent investment decisions; managers need it to operate their
organizations efficiently; and taxing authorities need it to assess taxes equitably.

Although financial reporting may seem straightforward, translating
physical assets and economic events into accounting numbers involves many
decisions, assumptions, and estimates. Nevertheless, that is what accountants
must do when they construct financial statements. To ensure the usefulness
of financial reports, regulators determine the form and disclosure of financial
information to users. This creates structure that facilitates comparisons and
raises the confidence in the information being reported.

1. What are the historical foundations of financial accounting
statements?

SELF-TEST
QUESTION

The Users of Financial Accounting Information

The predominant users of financial accounting information are those parties
that have a financial interest in the organization and hence are concerned

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 75

with its economic status. All organizations, whether not-for-profit or investor
owned, have stakeholders that have an interest in the business. In a not-for-
profit organization, such as a community hospital, the stakeholders include
managers, staff physicians, employees, suppliers, creditors, patients, and even
the community. Investor-owned hospitals have essentially the same set of stake-
holders, plus owners. Because all stakeholders, by definition, have an interest
in the organization, all stakeholders have an interest in its financial condition.

Among the outside stakeholders, investors, who supply the capital
(funds) needed by businesses, typically have the greatest financial interest in
health services organizations. Investors fall into two categories: (1) owners
who supply equity capital to investor-owned businesses and (2) creditors (or
lenders) who supply debt capital to both investor-owned and not-for-profit
businesses. (In a sense, communities supply equity capital to not-for-profit
organizations, so they, too, are investors.) In general, there is only one
category of owners. However, creditors constitute a diverse group of inves-
tors that includes banks, suppliers granting trade credit, and bondholders.
Because of their direct financial interest in healthcare businesses, investors
are the primary outside users of financial accounting information. They
use the information to form judgments about whether to make a particular
investment as well as to set the return required on the investment. (Investor-
supplied capital is covered in greater detail in chapters 11, 12, and 13.)

Although the field of financial accounting developed primarily to meet
the information needs of outside parties, the managers of an organization,
including its board of directors (trustees), also are important users of the
information. After all, managers are charged with ensuring that the organiza-
tion has the financial capability to accomplish its mission, whether that mis-
sion is to maximize the wealth of its owners or to provide healthcare services
to the community. Thus, an organization’s managers not only are involved
with creating financial statements but also are important users of those state-
ments, both to assess the current financial condition of the organization and
to formulate plans to ensure that the future financial condition of the orga-
nization will support its goals.

In summary, investors and managers are the predominant users of
financial accounting information as a result of their direct financial interest
in the organization. Furthermore, investors are not merely passive users of
financial accounting information; they do more than just read and interpret
the statements. Often, they create financial targets based on the numbers
reported in the financial statements that managers must attain or suffer some
undesirable consequence. For example, many debt agreements require bor-
rowers to maintain stated financial standards, such as a minimum earnings
level, to keep the debt in force. If the standards are not met, the lender can
demand that the business immediately repay the full amount of the loan. If
the business fails to do so, it may be forced into bankruptcy.

stakeholder
A party that
has an interest,
often financial,
in a business.
Stakeholders can
be affected by the
business’s actions,
objectives, or
policies.

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G apenski ’s Healthcare F inance76

1. What is a stakeholder?
2. Who are the primary users of financial accounting information?
3. How do investors use this information?

SELF-TEST
QUESTIONS

Regulation and Standards in Financial Accounting

As a consequence of the Great Depression of the 1930s, which caused many
businesses to fail and almost brought down the entire securities industry,
the federal government began regulating the form and disclosure of infor-
mation related to publicly traded securities. The regulation is based on the
theory that financial information constructed and presented according to
standardized rules allows investors to make the best-informed decisions.
The Securities and Exchange Commission (SEC), an independent regu-
latory agency of the US government formed in 1934, was given the author-
ity to establish and enforce the form and content of financial statements.
Nonconforming companies—that is, those whose financial statements do
not conform to SEC standards—are prohibited from selling securities to
the public, so many businesses comply to gain access to capital. Not-for-
profit corporations that do not sell securities still must file financial state-
ments with state authorities that conform to SEC standards. Finally, most
for-profit businesses that do not sell securities to the public are willing to
follow the SEC-established guidelines to ensure uniformity of presentation
of financial data. The result is that all businesses, except for the smallest,
create SEC-conforming financial statements.

Rather than directly manage the process, the SEC designates other
organizations to create and implement the standards system. For the most
part, the SEC has delegated the responsibility for establishing reporting
standards to the Financial Accounting Standards Board (FASB)—a pri-
vate organization whose mission is to establish and improve standards of
financial accounting and reporting for private businesses. (The Governmental
Accounting Standards Board has the identical responsibility for businesses
that are partially or totally funded by a government entity.) Typically, the
guidance issued by the FASB, which is promulgated by numbered state-
ments, applies across a wide range of industries and, by design, is general in
nature. More specific implementation guidance, especially when industry-
unique circumstances must be addressed, is provided by industry committees
established by the American Institute of Certified Public Accountants
(AICPA)—the professional association of public (financial) accountants. For
example, financial statements in the health services sector are based on the

Securities
and Exchange
Commission (SEC)
The federal
government
agency that
regulates the sale
of securities and
the operations
of securities
exchanges.
This agency
also has overall
responsibility for
the format and
content of financial
statements.

Financial
Accounting
Standards Board
(FASB)
A private
organization
whose mission
is to establish
and improve
the standards
of financial
accounting and
reporting for
private businesses.

American Institute
of Certified Public
Accountants
(AICPA)
The professional
association of
public (financial)
accountants.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 77

AICPA Audit and Accounting Guide titled Health Care Entities, which was
published most recently on September 1, 2018.

Because of the large number of statements and pronouncements that
have been issued by the FASB and other standard-setting organizations, the
FASB combined all of the previously issued standards into a single set called the
FASB Accounting Standards Codification, which became effective on Septem-
ber 15, 2009. The purpose of the codification is to simplify access to account-
ing standards by placing them in a single source and creating a system that
allows users to more easily research and reference accounting standards data.

When more specific guidance is required than the standards provide,
other professional organizations may participate in the process, although
such work does not have the same degree of influence as codification has. For
example, the Healthcare Financial Management Association has established
the Principles and Practices Board, which develops position statements and
analyses on issues that require further guidance.

When taken together, all the guidance contained in the codification
and the amplifying information constitute a set of guidelines called generally
accepted accounting principles (GAAP). GAAP can be thought of as a set
of objectives, conventions, and principles that have evolved through the years
to guide the preparation and presentation of financial statements. In essence,
GAAP sets the rules for financial statement preparation. Note, however, that
GAAP applies only to the area of financial accounting (financial statements),
as distinct from other areas of accounting, such as managerial accounting
(discussed in later chapters) and tax accounting.

It should be no surprise that the field of financial accounting is typically
classified as a social science rather than a physical science. However, finan-
cial accounting is as much an art as a science, and the end result represents
negotiation, compromise, and interpretation. The organizations involved in
setting standards are continuously reviewing and revising GAAP to ensure
the best possible development and presentation of financial data. This task,
which is essential to economic prosperity, is motivated by the fact that the US
economy is constantly evolving, with new types of business arrangements and
securities being created almost daily.

For large organizations, the final step in the financial statement quality
assurance process is the external audit, which is performed by an independent
(outside) auditor—usually one of the major accounting firms. The results of
the external audit are reported in the auditor’s opinion, which is a letter that
is attached to the financial statements stating whether the statements are a fair
presentation of the business’s operations, cash flows, and financial position
as specified by GAAP.

There are several categories of opinions given by auditors. The most
favorable, which is essentially a “clean bill of health,” is called an unqualified

generally
accepted
accounting
principles (GAAP)
The set of
guidelines that has
evolved to foster
the consistent
preparation and
presentation
of financial
statements.

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G apenski ’s Healthcare F inance78

opinion. Such an opinion means that, in
the auditor’s view, the financial statements
conform to GAAP, are presented fairly
and consistently, and contain all necessary
disclosures. A qualified opinion means that
the auditor has some reservations about
the statements, while an adverse opinion
means that the auditor believes that the
statements do not present a fair picture
of the financial status of the business. The
entire audit process, which is performed
by the organization’s internal auditors and
the external auditor, is a means of verifying
and validating the organization’s finan-
cial statements. Of course, an unqualified
opinion gives users, especially those exter-
nal to the organization, more confidence
that the statements truly represent the
business’s current financial condition.

Although the guidance given under
GAAP, along with auditing rules, would
seem to be sufficient to prevent fraudulent
financial statements, in the first decade of
the twenty-first century, several large com-
panies, including HealthSouth (now called
Encompass Health), which operates the
nation’s largest network of rehabilitation
services, were found to be manipulating
financial information.2 Because the US

financial system is so dependent on the reliability of financial statements, in
2002, Congress passed the Sarbanes-Oxley Act, generally known as SOX, as a
measure to improve transparency in financial accounting and to prevent fraud.
(According to the SEC, transparency means the timely, meaningful, and reli-
able disclosure of a business’s financial information.) Here are just a few of the
more important provisions of SOX:

• An independent body, the Public Accounting Oversight Board, was
created to oversee the entire audit process.

• Auditors can no longer provide non-auditing (consulting) services to
the companies that they audit.

• The lead partners of the audit team for any company must rotate off
the team every five years (or more often).

For Your Consideration
International Financial Reporting Standards

As the globalization of business continues, it
becomes more and more important for financial
accounting standards to be uniform across coun-
tries. The FASB and the International Accounting
Standards Board have been working jointly on
convergence, a process to develop a common set
of standards that will be accepted worldwide.
These standards, called International Financial
Reporting Standards (IFRS), ultimately will be
applicable to for-profit businesses in more than
150 countries, including the United States. Cur-
rently, more than 100 countries have adopted the
IFRS standards, but not the United States.1

A large number of details must be worked
out, and differences between current US and
international standards must be resolved. The
SEC has not yet decided whether to incorporate
IFRS standards in the United States. Also, the
impact of international standards on not-for-profit
organizations remains uncertain at this time.

What do you think? Should financial account-
ing standards apply to for-profit businesses
worldwide, as opposed to country by country?
What is the rationale behind your opinion?
Should not-for-profit organizations be subject to
international standards? Support your position.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 79

• Senior managers involved in the audits of their companies cannot
have been employed by the auditing firm during the one-year period
preceding the audit.

• Each member of the audit committee shall be a member of the
company’s board of directors and shall otherwise be independent of
the audit function.

• The chief executive officer and chief financial officer shall personally
certify that the business’s financial statements are complete and
accurate. Penalties for certifying reports that are known to be false
range up to a $5 million fine, 20 years in prison, or both. In addition,
if the financial statements must be restated because they are false,
certain bonuses and equity-based compensation that certifying
executives earned must be returned to the company.3

These provisions, along with others in SOX, are intended to deter future
fraudulent behavior by managers and auditors.

1. Why are widely accepted principles important for the measurement
and recording of economic events?

2. What entities are involved in regulating the development and
presentation of financial statements?

3. What does GAAP stand for, and what is its primary purpose?
4. What is the purpose of the auditor’s opinion?
5. What is the purpose of the Sarbanes-Oxley Act (SOX), and what

are some of its provisions?

SELF-TEST
QUESTIONS

Conceptual Framework of Financial Reporting

Because the actual preparation of financial statements is done by accountants,
a detailed presentation of accounting theory is not required in this book.
However, to better understand the content of financial statements, it is useful
to discuss some aspects of the conceptual framework that accountants apply
when they develop financial accounting data and prepare an organization’s
financial statements. By understanding this framework, readers will be better
prepared to understand and interpret the financial statements of healthcare
organizations.

In Statement of Financial Accounting Concepts No. 8, which was
amended in August 2018, the FASB states, “The objective of general purpose
financial reporting is to provide financial information about the reporting

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G apenski ’s Healthcare F inance80

entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.”4 To
achieve this objective, the FASB specifies the fundamental concepts, assump-
tions, and principles that underlie the development of financial accounting
and reporting guidance (i.e., GAAP).

Qualitative Characteristics of Financial Accounting Data
Relevance
Financial accounting data are relevant if the information has the potential to
make a difference in the decisions of users. Relevant data help users make
predictions about an organization’s future performance or confirm their prior
or current understanding of the organization’s performance.

Faithful Representation
Financial accounting data faithfully represent economic activity if they are
complete, neutral (free of bias, either positive or negative), and free from
error. It is important to note that faithful representation does not necessar-
ily mean that information is accurate; since many assumptions and estimates
are required in measuring and reporting economic activity, accuracy cannot
always be determined with certainty.

The usefulness of financial accounting data is additionally enhanced if
those data possess four characteristics:

1. Comparability. Comparability means that similar items are measured
and reported in a similar way to allow comparisons across different
organizations as well as within organizations over time.

2. Verifiability. Financial accounting information is verifiable if
independent observers, such as auditors, would concede that the data
faithfully represent economic activity.

3. Timeliness. Timeliness means that decision makers have data in time
to influence their decisions.

4. Understandability. Understandability means that data are classified,
characterized, and presented in a way that users can understand the
information that is being conveyed.

Assumptions
Accounting Entity
The first assumption is the ability to define the accounting entity, which
is important for two reasons. First, for investor-owned businesses, financial
accounting data must be pertinent to the business activity as opposed to the
personal affairs of the owners. Second, within any business, the accounting
entity defines the specific areas of the business to be included in the state-
ments. For example, a healthcare system may create one set of financial

accounting entity
The entity
(business) for
which a set
of financial
statements
applies.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 81

statements for the system as a whole and separate sets of statements for its
subsidiary hospitals. In effect, the accounting entity specification establishes
boundaries that tell readers what business (or businesses) is being reported on.

Going Concern
It is assumed that the accounting entity will operate as a going concern and
hence will have an indefinite life. Going concern means that assets, in general,
should be valued on the basis of their contribution to an ongoing business as
opposed to their current fair market value. For example, the land, buildings,
and equipment of a hospital may have a value of $50 million when they are
used to provide patient services, but if they were sold to an outside party
for other purposes, the value of these assets might only be $20 million. The
going concern assumption, coupled with the fact that financial statements
must be prepared for relatively short periods (as explained next), means that
financial accounting data are not exact, but rather represent logical and sys-
tematic approaches applied to complex measurement problems.

Periodicity
Because accounting entities are assumed to have an indefinite life, but users
of financial statements require timely information, it is common to report
financial results on a relatively short periodic basis. The period covered,
called an accounting period, can be any length of time over which an orga-
nization’s managers, or outside parties, want to evaluate operational and
financial results. Most health services organizations use calendar periods—
months, quarters, and years—as their accounting periods. However, occa-
sionally an organization will use a fiscal year (financial year) that does not
coincide with the calendar year. For example, the federal government’s fiscal
year runs from October 1 to September 30. Although annual accounting
periods are typically used for illustrations in this book, financial statements
commonly are prepared for periods shorter than one year. For example,
many organizations prepare semiannual and quarterly financial statements in
addition to annual statements.

Monetary Unit
The monetary unit provides the common basis by which economic events are
measured. In the United States, this unit is the dollar, unadjusted for inflation
or deflation. Thus, all transactions and events must be expressed in dollar terms.

Principles
Historical Cost
The historical cost principle requires organizations to report the values of
many assets based on acquisition costs rather than fair market value, which
implies that the dollar has constant purchasing power over time. In other

accounting period
The period
(amount of time)
covered by a
set of financial
statements—
often a year, but
sometimes a
quarter or another
time period.

fiscal year
The year
covered by an
organization’s
financial
statements;
it usually, but
not necessarily,
coincides with the
calendar year.

historical cost
In accounting, the
purchase price of
an asset.

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G apenski ’s Healthcare F inance82

words, land that cost $1 million 20 years ago might be worth $2 million
today, but it is still reported at its initial cost of $1 million. The accounting
profession has grappled with the inflation impact problem for years but has
not yet developed a feasible solution. The historical cost principle removes
subjectivity in the measurement of an asset’s value, but it does not provide
the most current information. We should note, however, that some items
(primarily financial security holdings) are reported at fair market value.

Revenue Recognition
The revenue recognition principle requires that revenues be recognized
in the period in which they are realizable and earned. Generally, this is the
period in which the service is rendered, because at that point, the price is
known (realizable) and the service has been provided (earned). However, in
some instances, difficulties in revenue recognition arise, primarily when the
revenue amount or the completion of the service is uncertain.

Expense Matching
The expense-matching principle requires that an organization’s expenses be
matched, to the extent possible, with the revenues to which they relate. In other
words, after the revenues have been allocated to a particular accounting period,
all expenses associated with producing those revenues should be matched to
the same period. Although this concept is straightforward, implementation of
the matching principle creates some challenges. For example, consider long-
lived assets such as buildings and equipment. Because such assets—for example,
a magnetic resonance imaging (MRI) machine—provide revenues for several
years, the expense-matching principle dictates that its acquisition cost should be
spread over the same number of years. Thus, methods are required for estimat-
ing the amount of assets to be moved to expenses in a given year.

Full Disclosure
Financial statements must contain a complete picture of the economic events
of the business. Anything less would be misleading by omission. Furthermore,
because financial statements must be relevant to a diversity of users, the full-
disclosure principle pushes preparers to include even more information in finan-
cial statements. However, the complexity of the information presented can be
mitigated to some extent by placing some information in the notes or supple-
mentary information sections as opposed to the body of the financial statements.

Thresholds and Constraints
Materiality Threshold
If the financial statements contained all possible information, they would be
so long and detailed that making inferences about the organization would be

revenue
recognition
principle
The concept that
revenues must be
recognized in the
accounting period
in which they are
realizable and
earned.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 83

difficult without a great deal of analysis. Thus, to keep the statements man-
ageable, only entries that are important to the operational and financial status
of the organization need to be separately identified. For example, medical
equipment manufacturers carry large inventories of materials that are both
substantial in dollar value relative to other assets and instrumental to their
core business, so such businesses report inventories as a separate asset item on
the balance sheet. Hospitals, on the other hand, carry relatively small inven-
tories. Thus, many hospitals and other healthcare providers do not report
inventories separately but combine them with other assets. In general, the
materiality threshold affects the presentation of the financial statements rather
than their aggregate financial content (i.e., the final numbers).

Cost–Benefit Constraint
There are costs associated with financial statement information for both the
preparers of the statements and the users. Preparers must collect, record, ver-
ify, and report financial information, while users must analyze and interpret
the information. As a result, financial statements cannot report all possible
information that every potential user might find relevant. When deciding
what information should be reported, and how that information should be
reported, standards setters and accountants must determine whether the
benefits of the information outweigh the associated costs.

1. Why is it important to understand the basic concepts that underlie
the preparation of financial statements?

2. What is the goal of financial reporting?
3. Briefly explain the following concepts as they apply to the

preparation of financial statements:
a. Relevance
b. Faithful representation
c. Accounting entity
d. Going concern
e. Accounting period
f. Monetary unit
g. Historical cost
h. Revenue recognition
i. Expense matching
j. Full disclosure
k. Materiality
l. Cost–benefit

SELF-TEST
QUESTIONS

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G apenski ’s Healthcare F inance84

Accounting Methods: Cash Versus Accrual

In the implementation of the conceptual framework discussed in the previous
section, two methods can be applied: cash accounting and accrual account-
ing. Although, as we discuss later, each method has its own set of advantages
and disadvantages, GAAP specifies that only the accrual method can receive
an unqualified auditor’s opinion, so accrual accounting dominates the prepa-
ration of financial statements. Still, many small businesses that do not require
audited financial statements use the cash method, and knowledge of the cash
method aids our understanding of the accrual method, so we discuss both
methods here.

Cash Accounting
Under cash accounting, often called cash basis accounting, economic events
are recognized—that is, put into the financial statements—when the cash
transaction occurs. For example, suppose Sunnyvale Clinic, a large, multi-
specialty group practice, provided services to a patient in December 2020.
At that time, the clinic billed Florida Blue (formerly Blue Cross and Blue
Shield of Florida) $700, the full amount that the insurer was obligated to pay.
However, Sunnyvale did not receive payment from the insurer until February
2021. If it used cash accounting, the $700 obligation on the part of Florida
Blue would not appear in Sunnyvale’s 2020 financial statements. Rather, the
revenue would be recognized when the cash was actually received in Febru-
ary 2021.

The core argument in favor of cash accounting is that the most impor-
tant event to record on the financial statements is the receipt of cash, not the
provision of the service (i.e., the obligation to pay). Similarly, Sunnyvale’s
costs of providing services would be recognized as the cash is physically paid
out: Inventory costs would be recognized as supplies are purchased, labor
costs would be recognized when employees are paid, new equipment pur-
chases would be recognized when the invoices are paid, and so on. To put
it simply, cash accounting records the actual flow of money into and out of
a business.

Cash accounting has two advantages. First, it is simple and easy to
understand. No complex accounting rules are required for the prepara-
tion of financial statements. Second, cash accounting is closely aligned with
accounting for tax purposes, and hence it is easy to translate cash accounting
statements into income tax filing data. Because of these advantages, about
80 percent of all medical practices, typically smaller ones, use cash account-
ing. However, cash accounting also has disadvantages—primarily, that in its
pure form, it does not present information on revenues owed to a business
by payers or the business’s existing payment obligations.

cash accounting
The recording of
economic events
when a cash
exchange takes
place.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 85

Before closing our discussion of cash accounting, we should note that
most businesses that use cash accounting do not use the “pure” method
described here but rather a hybrid method called modified cash basis account-
ing. The modified statements combine some features of cash accounting,
usually to report revenues and expenses, and some features of accrual
accounting, usually to report assets and liabilities. Still, the cash method
presents an incomplete picture of the financial status of a business and hence
the preference for accrual accounting by GAAP.

Accrual Accounting
Under accrual accounting, often called accrual basis accounting, the eco-
nomic event that creates the financial transaction (e.g., patient surgery is
performed), rather than the financial transaction itself (e.g., insurer pays the
hospital for the surgery), provides the basis for the accounting entry. When
applied to revenues, the accrual concept implies that revenue earned and
reported does not necessarily correspond to the actual receipt of cash at the
time the revenue is reported. Why? Earned revenue is recognized in financial
statements when a service is provided that creates a payment obligation on
the part of the payer, rather than when the payment is actually received. For
healthcare providers, the payment obligation typically falls on the patient,
a third-party payer, or both. If the obligation is satisfied immediately—
for example, when a patient makes full payment at the time the service is
rendered—the revenue is in the form of cash. In such cases, the revenue is
recorded at the time of service regardless of whether cash or accrual account-
ing is used.

However, in most cases, the bulk of the payment for a service comes
from a third-party payer and is not received until later, perhaps several
months after the service is provided. In this situation, the revenue created
by the service does not create an immediate cash payment. If the payment
is received within an accounting period—one year, for our purposes—the
conversion of revenues to cash will be completed, and as far as the financial
statements are concerned, the reported revenue is cash. However, when the
revenue is recorded (i.e., the service is provided) in one accounting period
and payment does not occur until the next period, the revenue reported has
not yet been collected.

Consider the Sunnyvale Clinic example presented in our discussion of
cash accounting. Although the services were provided in December 2020,
the clinic did not receive its $700 payment until February 2021. Because
Sunnyvale’s accounting year ended on December 31 and the clinic uses
accrual accounting, the clinic’s books were closed after the revenue had
been recorded but before the cash was received. Thus, Sunnyvale reported
this $700 of revenue on its 2020 financial statements, even though no cash

accrual accounting
The recording of
economic events
in the periods in
which the events
occur, even if
the associated
cash receipts or
payments happen
in a different
period.

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G apenski ’s Healthcare F inance86

was collected. When accrual accounting is used, the amount of revenues
not collected is listed as a receivable (the amount due to Sunnyvale) in the
financial statements, so users will know that not all reported revenues rep-
resent cash receipts.

The accrual accounting concept also applies to expenses. To illustrate,
assume that Sunnyvale had payroll obligations of $20,000 for employees’
work during the last week of 2020 that would not be paid until the first pay-
day in 2021. Because the employees actually performed the work, the obliga-
tion to pay the salaries was created in 2020. An expense would be recorded in
2020 even though no cash payment would be made until 2021. Under cash
basis accounting, Sunnyvale would not recognize the labor expense until it
was paid—in this case, in 2021. But under accrual accounting, the $20,000
would be shown as an expense on the financial statements in 2020, and, at
the same time, the statements would indicate a $20,000 liability (or obliga-
tion to pay employees).

1. Briefly explain the differences between cash and accrual accounting
and give an example of each.

2. What is modified cash basis accounting?
3. Why does GAAP favor accrual over cash accounting?

SELF-TEST
QUESTIONS

Income Statement Basics

In this section, we begin our coverage of the four primary financial state-
ments by discussing the income statement. Then, in a later section, we
discuss the statement of changes in equity. In chapter 4, the remaining two
statements—the balance sheet and the statement of cash flows—are dis-
cussed. The supplement to chapter 4 discusses the method of recording and
compiling the financial accounting data contained in the financial statements.
Unfortunately, the names of the statements are not consistent across types
of organizations. We will introduce the alternative names of each statement
as it is discussed.

The purpose of our financial accounting discussion is to provide read-
ers with a basic understanding of the preparation, content, and interpretation
of a business’s financial statements. The financial statements of large organiza-
tions can be long and complex, and there is significant leeway regarding the
format used, even within health services organizations. Thus, in our discus-
sion of the statements, we use simplified illustrations that focus on key issues.
In a sense, the financial statements presented here are summaries of actual

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 87

financial statements, but this is the best way to learn the basics; the nuances
must be left to other books that focus exclusively on accounting matters.

Perhaps the most frequently asked, and the most important, ques-
tion about a business is this: Is it making money? The income statement
summarizes the operations (activities) of an organization with a focus on
its revenues, expenses, and profitability. The income statement is also called
the statement of operations, statement of activities, or statement of revenues
and expenses.

The income statements of Sunnyvale Clinic are presented in exhibit
3.1. Because Sunnyvale is a not-for-profit organization, its income statement
is called the statement of operations. The statement also includes changes in
net assets, which is the not-for-profit equivalent of the statement of changes
in equity. For now, we will focus on the statement of operations. The state-
ment of changes in net assets is discussed later in this chapter.

Most financial statements contain two or three years of data, with the
most recent year presented first. The title section tells us that these are annual
income statements, ending on December 31, for the years 2020 and 2019.
Whereas the balance sheet, which is covered in chapter 4, reports a business’s
financial position at a single point in time, the income statement contains
operational results over a specified period of time. Because these income state-
ments are part of Sunnyvale’s annual report, the time (accounting) period is
one year. Also, the dollar amounts reported are listed in thousands of dollars,
so the $148,118 listed as net patient service revenue for 2020 is actually
$148,118,000.

The core components of the income statement are straightforward:
revenues, expenses, and profitability (net operating income and net income).
Revenues, as discussed in the section on cash versus accrual accounting, rep-
resent both the cash received and the unpaid obligations of payers for services
provided during each year presented. For healthcare providers, revenues
result mostly from the provision of patient and patient-related services.

To produce revenues, organizations must incur expenses, which are
classified as operating or capital. Although they are not separately broken out
on Sunnyvale’s income statement, operating expenses consist of salaries, sup-
plies, insurance, and other costs directly related to providing services. Capital
costs are the costs associated with the buildings and equipment used by the
organization, such as depreciation and interest expenses. Expenses decrease
the profitability of a business, so expenses are subtracted from revenues to
determine an organization’s profitability. Sunnyvale’s income statement
reports two different measures of profitability: operating income and net
income (called excess of revenues over expenses).

The income statement, then, summarizes the organization’s ability to
generate profits. Basically, it lists the organization’s revenues (and income),

income statement
A financial
statement,
prepared in
accordance with
generally accepted
accounting
principles (GAAP),
that summarizes
a business’s
revenues,
expenses, and
profitability.

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G apenski ’s Healthcare F inance88

2020 2019

Operations

Operating Revenues:

Net patient service revenue $ 148,118 $ 121,765

Premium revenue 17,316 16,455

Other revenue 3,079 2,704

Net operating revenues $ 168,513 $140,924

Expenses:

Salaries and benefits $126,223 $ 102,334

Supplies 20,568 18,673

Insurance 4,518 3,710

Purchased services 3,189 2,603

Depreciation 6,405 5,798

Interest 5,329 3,476

Total expenses $166,232 $ 136,594

Operating income $ 2,281 $ 4,330

Nonoperating income:

Contributions $ 243 $ 198

Investment income 3,870 3,678

Total nonoperating income $ 4,113 $ 3,876

Excess of revenues over
expenses (net income)

$ 6,394 $ 8,206

Changes in Net Assets

Changes in net assets without
donor restrictions:

Excess of revenues over
expenses

$ 6,394 $ 8,206

Increase in net assets without
donor restrictions

$ 6,394 $ 8,206

Changes in net assets with
donor restrictions:

Gifts and bequests $ 1,466 $ 0

Increase in net assets with
donor restrictions

$ 1,466 $ 0

Increase in net assets $ 7,860 $ 8,206

Net assets at beginning of year $ 46,208 $ 38,002

Net assets at end of year $ 54,068 $ 46,208

EXHIBIT 3.1
Sunnyvale

Clinic:
Statements

of Operations
and Changes

in Net Assets,
Years Ended

December 31,
2020 and 2019
(in thousands)

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 89

the expenses that must be incurred to produce the revenues, and the differ-
ences between the two. In the following sections, the major components of
the income statement are discussed in detail.

1. What is the primary purpose of the income statement?
2. In regard to time, how do the income statement and balance sheet

differ?
3. What are the major components of the income statement?

SELF-TEST
QUESTIONS

Revenues

Revenues can be shown on the income statement in several different formats.
In fact, there is more latitude in the construction of the income statement
than there is in that of the balance sheet, so the income statements for dif-
ferent types of healthcare providers tend to differ more in presentation than
their balance sheets. (See problems 3.2 and 3.3, as well as exhibit 17.1, for
examples of income statements from other types of providers.)

Sunnyvale’s operating revenues section (see exhibit 3.1) focuses on
revenues that stem from the provision of patient and patient-related services;
in other words, they derive from operations. As we discuss in a later section,
Sunnyvale also has revenues from contributions and securities investments
(nonoperating income), but because such income is not related to core busi-
ness activities, it is reported separately on the income statement.

The first line of the operating revenues section reports net patient
service revenue of $148,118,000 for 2020. The key term here is net patient
service. Patient service means that this line contains revenues that stem solely
from patient services, as opposed to revenues that stem from related sources,
such as parking fees or food services, which are reported on a separate line
(other revenue) in the operating revenues section. Also, as discussed later,
patient service revenue that stems from capitated patients may be reported
separately (e.g., premium revenue). If this is the case, the $148,118,000
reported by Sunnyvale as patient service revenue includes only revenue from
fee-for-service patients.

Net patient service revenue means that the patient service revenue
reported is the amount that Sunnyvale expects to receive for providing
patient care after accounting for certain deductions. Sunnyvale, like all
healthcare providers, has a charge description master file, or chargemaster,
that contains the charge code and gross price for each item and service that
it provides. However, the chargemaster price rarely represents the amount

patient service
revenue
Revenue that
stems solely from
the provision of
patient services; in
some situations,
it may only reflect
revenue from
fee-for-service
patients.

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G apenski ’s Healthcare F inance90

the clinic expects to be paid for a particular service. For example, the price
for a particular service might be $800, but the contract with a particular
payer might specify a 40 percent discount from charges, which would result
in a reimbursement of only $480. In addition to negotiated discounts, gov-
ernment payers such as Medicare and Medicaid reimburse providers a set
amount that often is well below the chargemaster (gross) price.

Because recorded revenue must reflect only amounts that are realiz-
able (collectible), differences between chargemaster prices and actual reim-
bursement amounts are incorporated before the revenue is recorded on the
net patient service revenue line. Thus, the net patient service revenue shown
on the income statement is reported after contractual allowances have been

considered and hence represents the actual
reimbursement amount expected.

To add to the complexity of rev-
enue reporting, some services have been
provided as financial assistance (char-
ity care) to indigent patients. (Indigent
patients are those who presumably are
willing to pay for services provided but do
not have the ability to do so.) Sunnyvale
has no expectation of ever collecting for
these services, so, like contractual allow-
ances, charges for charity care services are
not reflected in the $148,118,000 net
patient service revenue reported for 2020.

Finally, some payments for patient
services that are owed will never be col-
lected. Prior to 2018 (for public enti-
ties) and 2019 (for nonpublic entities),
estimates of these amounts were reported
separately on the income statement as a
deduction from patient service revenue
titled provision for bad debts or provision
for uncollectible accounts (see exhibit 3.2,
column labeled “Before”). However, in
2014, the FASB issued a new account-
ing pronouncement that changed the
reporting of patient service revenue begin-
ning in 2018 or 2019 depending on the
type of organization.5 After its adoption,
the majority (or all) of what previously
would have been classified as provision for
uncollectible accounts and presented as a

Healthcare in Practice
Revenue Reporting in the “Good Old Days”

About 20 years ago, hospital revenues were
reported differently than they are today. Then,
the revenues section would begin with gross
patient services revenue based on chargemaster
prices. In other words, every service provided
would be recorded at its chargemaster price, and
those prices would be aggregated to calculate
reported revenues.

Then, the total amount of discounts and
allowances would be listed, followed by the total
amount of charity care provided, and those values
would be subtracted from gross patient service
revenue to obtain net patient service revenue. In
this format, discounts and allowances and char-
ity care were prominently displayed at the top of
the income statement. At the time, estimates of
bad debt losses were reported as an expense.
Later, bad debt losses were treated as a revenue
deduction, and now they are treated mostly as an
implicit price concession and not reported sepa-
rately. Today, if these amounts (discounts and
allowances, charity care, and bad debt losses) are
listed at all, they typically are listed in the notes
to the financial statements rather than in the
income statement itself.

What do you think? Is the “old” way or the
current system best? Why do you think GAAP was
changed to report only the net amount expected
to be collected, as opposed to the gross amount
billed less all of the deductions?

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 91

reduction to patient service revenue on the income statement must now be
treated as a price concession that reduces the transaction price reported as
net patient service revenue.

The FASB defines two types of price concessions: explicit and implicit.
Explicit price concessions are based on contractual agreements, established
discount policies, and historical experience (e.g., contractual allowances and
financial assistance, as discussed previously). Implicit price concessions rep-
resent differences between amounts billed and estimated amounts expected
to be received from patients based on historical collection experience and
current market factors. Thus, what was previously classified as bad debt is
now considered an implicit price concession and treated like contractual
allowances and financial assistance in the presentation of net patient service
revenue. As shown in exhibit 3.2 (column labeled “After”), all that is now
reported is a single line titled net patient service revenue, which is net of
discounts and allowances, charity care and financial assistance, and implicit
price concessions. Any true (unpredictable) bad debt losses are reported as
an expense under the new accounting standard. While the change affects the
presentation of patient service revenue on the income statement, it is not
expected to materially affect net income.

A description of policies regarding discounts and charity care often
appears in the notes to the financial statements. Sunnyvale’s financial state-
ments include the following two notes:

Revenues. Sunnyvale has entered into agreements with third-party payers, includ-

ing government programs, under which it is paid for services on the basis of estab-

lished charges, the cost of providing services, predetermined rates, or discounts

from established charges. Revenues are recorded at estimated amounts due from

patients and third-party payers for the services provided. Settlements under reim-

bursement agreements with third-party payers are estimated and recorded in the

period the related services are rendered and are adjusted in future periods, as

final settlements are determined. The adjustments to estimated settlements for

prior years are not considered material and thus are not shown in the financial

statements or notes.

Statement of Operations and Changes in Net Assets (in thousands)

After Before

Patient service revenue net of contractual dis-
counts and allowances $8,308,889

Provision for uncollectible accounts (254,569)

Net patient service revenue $8,054,320 $8,054,320

EXHIBIT 3.2
Presentation of
Patient Service
Revenue Before
and After
Implementation
of the FASB’s
New Revenue
Recognition
Standard

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G apenski ’s Healthcare F inance92

Charity care. Sunnyvale has a policy of providing charity care to indigent patients

in emergency situations. These services, which are not reported as revenues,

amounted to $67,541 in 2020 and $51,344 in 2019.

Even though Sunnyvale ultimately expects to collect all of its reported
net patient service revenue, the clinic did not actually receive $148,118,000
in cash payments from fee-for-service patients and insurers in 2020. Rather,
some of the revenue has not yet been collected. As readers will learn
in chapter 4, the yet-to-be-collected portion of the net patient service
revenue—$28,509,000—appears on the balance sheet (see exhibit 4.1) as net
patient accounts receivable.

If a provider has a significant amount of revenue stemming from
capitation contracts, it is often reported separately in the operating rev-
enues section as premium revenue. Sunnyvale reported premium revenue
of $17,316,000 for 2020. The key difference is that patient service revenue
is reported when services are provided, but premium revenue is reported
at the start of each contract payment period—typically the beginning of
each month. Thus, premium revenue implies an obligation on the part of
the reporting organization to provide future services, while patient service
revenue represents an obligation on the part of payers to pay the reporting
organization for services already provided. Also, different types of provid-
ers may use different terminology for revenues; for example, some nursing
homes report resident service revenue.

Most health services organizations have revenue related to, but not
arising directly from, patient services, and Sunnyvale is no exception. In
2020, Sunnyvale reported other revenue of $3,079,000. Examples of other
revenue include parking fees; nonpatient food service charges; office and
concession rentals; and sales of pharmaceuticals to employees, staff, and
visitors.

When all the revenue associated with patient services is totaled, the
amount reported as net operating revenues for 2020 is $168,513,000. This
amount represents the net amount of revenue that stems from a provider’s
core operations—the provision of patient services. Income that results from
noncore activities—primarily contributions and securities investments—is
reported at the bottom of the income statement.

1. What categories of revenue are reported on the income statement?
2. Briefly, what is the difference between gross patient service

revenue and net patient service revenue?

SELF-TEST
QUESTIONS

premium revenue
Patient service
revenue that stems
from capitated
patients as
opposed to fee-for-
service patients.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 93

3. Describe how the following adjustments to revenue are reported
on the income statement:
a. Contractual discounts and allowances
b. Charity care
c. Implicit price concessions (formerly bad debt losses)

4. Is income from securities investments included in the operating
revenue section? If not, why not?

SELF-TEST
QUESTIONS

Expenses

Expenses are the costs of doing business. As shown in exhibit 3.1, Sunny-
vale reports its expenses in categories such as salaries and benefits, supplies,
insurance, and so on. According to GAAP, expenses may be reported using
either a natural classification, which classifies expenses by the nature of the
expense, as Sunnyvale does, or a functional classification, which classifies
expenses by purpose, such as inpatient services, outpatient services, and
administrative.

The number and nature of expense items reported on the income
statement can vary widely depending on the nature and complexity of the
organization. For example, some businesses, typically smaller ones, may
report only two categories of expenses: health services and administrative.
Others may report many categories. Sunnyvale takes a middle-of-the-road
approach to the number of expense categories. Most users of financial state-
ments would prefer more expense categories, as well as a mixing of clas-
sifications, because more insights can be gleaned if an organization reports
revenues and expenses both by service breakdown (e.g., inpatient versus
outpatient) and by type (e.g., salaries versus supplies). To assist readers,
some organizations present additional detail on expenses in the notes to the
financial statements.

Sunnyvale is typical of most healthcare providers in that its cost struc-
ture is primarily related to labor. The clinic reported salaries and benefits of
$126,223,000 for 2020, which amounts to 75 percent of Sunnyvale’s total
expenses. The way in which these expenses are broken down—by depart-
ment or by contract—and the relationship of these expenses to the volume or
type of services provided is not part of the financial accounting information
system. However, such information, which is very important to managers, is
available in Sunnyvale’s managerial accounting system. Chapters 5–8 focus
on managerial accounting.

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G apenski ’s Healthcare F inance94

The expense item titled supplies represents the cost of supplies (pri-
marily medical) used in providing patient services. Sunnyvale does not order
and pay for supplies when a particular patient service requires them. Rather,
the clinic’s manager estimates the use of individual supply items, orders
them beforehand, and then maintains a supplies inventory. As readers will
see in chapter 4, the amount of supplies on hand is reported on the balance
sheet. The income statement expense reported by Sunnyvale represents the
cost—$20,568,000—of the supplies actually consumed in providing patient
services for 2020 (recall the expense-matching principle). Thus, the expense
reported for supplies does not reflect the actual cash spent by Sunnyvale on
supplies purchased during the year. In theory, Sunnyvale could have several
years’ worth of supplies in its inventories at the beginning of 2020; it could
have used some of those supplies without replenishing inventories, and hence
it might not have actually spent any cash on supplies during 2020.

Sunnyvale uses commercial insurance to protect against many risks,
including property risks, such as fire and damaging weather, and liability
risks, such as managerial malfeasance and professional (medical) liability.
The cost of this protection is reported on the income statement as insurance
expense, which amounted to $4,518,000 in 2020.

Sunnyvale uses a third-party provider for its reference laboratory. This
$3,189,000 expense for 2020 is reported as purchased services on the income
statement.

The next expense category, depreciation, requires closer examination.
Businesses require property and equipment (fixed assets) to provide goods
and services. Sunnyvale owns most of the fixed assets necessary to support
its mission. When fixed assets are initially purchased, Sunnyvale does not
report their cost as an expense on the income statement. The reason is that
the expense-matching principle dictates that such costs be matched to the
accounting periods during which the asset produces revenues. A more prag-
matic reason for not reporting the costs of fixed assets when they are acquired
is that reported earnings can fluctuate widely from year to year depending on
the amount of fixed assets acquired.

To match the cost of fixed assets to the revenues produced by such long-
lived assets, accountants use the concept of depreciation expense, which spreads
the cost of a fixed asset over many years. Note that most people use the terms
cost and expense interchangeably. To accountants, however, the terms can have
different meanings. Depreciation expense is a good example. Here, the term cost
is applied to the actual cash outlay (total expenditure) for a fixed asset, whereas
the term expense is used to describe the allocation of that cost over time.

The calculation of depreciation expense is somewhat arbitrary, so the
amount of depreciation expense applied to a fixed asset in any year generally
is not closely related to the actual use of the asset or its loss in fair market
value. To illustrate, Sunnyvale owns a piece of diagnostic equipment that it
uses infrequently. In 2019, it was used 23 times, but in 2020, it was used only

depreciation
A noncash charge
against earnings
on the income
statement that
reflects the “wear
and tear” on a
business’s fixed
assets (property
and equipment).

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 95

nine times. Still, the depreciation expense associated with this equipment
was the same in both years. Also, the clinic owns another piece of equipment
that could be sold today for about the same price that Sunnyvale paid for it
four years ago, yet each year the clinic reports a depreciation expense for that
equipment, which implies a loss of value.

Depreciation expense, like all other financial statement entries, is cal-
culated in accordance with GAAP. The calculation typically uses the straight-
line method—that is, the depreciation expense is obtained by dividing the
historical cost of the asset, less its estimated salvage value, by the number of
years of its estimated useful life (the period of time over which the asset is in
service and generates revenues). Salvage value is the amount, if any, expected
to be received when final disposition occurs at the end of an asset’s useful
life. The result is the asset’s annual depreciation expense, which is the charge
reflected in each year’s income statement over the estimated life of the asset.
In 2020, Sunnyvale reported depreciation expense of $6,405,000, which
represents the total amount of deprecation taken on all of the clinic’s fixed
assets during the year. (The term straight line stems from the fact that the
depreciation expense is constant in each year, and hence the implied value
of the asset declines evenly—like a straight line—over time.) As readers will
discover in chapter 4, depreciation is accumulated over time on the organiza-
tion’s balance sheet.

In addition to depreciation calculated for financial statement purposes,
which is called book depreciation, for-profit businesses must calculate depre-
ciation for tax purposes. Tax depreciation is calculated in accordance with
Internal Revenue Service regulations, as opposed to GAAP. Also, note that
land is not depreciated for either financial reporting or tax purposes.

In closing our discussion of depreciation expense, note that deprecia-
tion is a noncash expense, meaning there is no actual payment associated with
the expense. The cash payment may have been made many years before the
expense appears on the income statement. The impact of noncash expenses
on a business’s cash flows is covered in a later section of this chapter.

Key Equation: Straight-Line Depreciation Calculation
Suppose Sunnyvale Clinic purchases an X-ray machine for $150,000.
Its useful life, according to accounting guidelines, is ten years, and the
machine’s expected salvage value at that time is $25,000. The annual
depreciation expense, calculated as follows, is $12,500:

Annual depreciation expense = (Initial cost − Salvage value) ÷ Useful life
= ($150,000 − $25,000) ÷ 10 years
= $125,000 ÷ 10
= $12,500.

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G apenski ’s Healthcare F inance96

The final expense line reports interest expense. Sunnyvale owes or paid
its lenders $5,329,000 in interest expense for debt capital supplied dur-
ing 2020. Not all of the interest expense reported has been paid, because
Sunnyvale typically pays interest monthly or semiannually, and hence interest
has accrued on some loans that will not be paid until 2021. The amount of
interest expense reported by an organization is influenced primarily by its
capital structure, which reflects the amount of debt that it uses. Also, interest
expense is affected by the borrower’s creditworthiness, its mix of long-term
versus short-term debt, and the general level of interest rates. (These factors
are discussed in detail in later chapters.)

In closing our discussion of expenses, note that many income state-
ments contain a catchall category labeled “other.” Listed here are general
and administrative expenses that individually are too small to list separately,
including items such as marketing expenses and external auditor fees.
Although organizations cannot possibly report every expense item separately,
it is frustrating for users of financial statement information to come across a
large, unexplained expense item. Thus, income statements that include the
“other” category often add a note that provides additional detail regarding
these expenses.

1. What is an expense?
2. Briefly, what are some of the commonly reported expense categories?
3. What is the logic behind depreciation expense?

SELF-TEST
QUESTIONS

Operating Income

Although the reporting of revenues and expenses is clearly important, the
most important information on the income statement is profitability. As
shown in exhibit 3.1, two different profit measures can be reported on the
income statement. (Not all healthcare organizations report both measures.
Some report only the final measure—net income.)

The first profitability measure reported by Sunnyvale Clinic is oper-
ating income, which is calculated in exhibit 3.1 as net operating revenues
minus total expenses. The precise calculation is tied to the format of the
income statement, but the general idea of operating income is to focus
on revenues and expenses that are related to operations (the provision of
patient services).

operating income
The earnings
of a business
directly related
to core activities;
for a healthcare
provider, earnings
are related to
patient services.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 97

Because net operating revenues
in exhibit 3.1 are all related to patient
services, operating income measures the
profitability of core operations (patient
services and related endeavors). Many
healthcare providers, especially large ones,
have significant revenues that stem from
non-patient-service-related activities, so it
is useful to report the inherent profitabil-
ity of the core business separately from the
overall profitability of the enterprise.

Sunnyvale reported $2,281,000 of
operating income in 2020, which means
that the provision of healthcare services
and directly related activities generated a
profit of that amount. Operating income
is an important measure of a healthcare
business’s profitability because it focuses
on the core activities of the business. Some
healthcare businesses report a positive net
income (net income is discussed later) but
a negative operating income (an operating
loss). This situation is worrisome, because
a business is on shaky financial ground if
its core operations are losing money, espe-
cially if they do so year after year.

The operating income reported on
the income statement is defined by GAAP
and represents an estimate of the long-run
operating profitability of the business. It has some shortcomings—for one,
it does not represent cash flow—that are similar to the shortcomings related
to net income, which are discussed in a later section of this chapter. Still,
measuring the core profitability of a business is critical to understanding its
financial status.

1. What is operating income?
2. Why is operating income such an important measure of

profitability?

SELF-TEST
QUESTIONS

For Your Consideration
Will the Real Operating Income
Please Stand Up?

Who would think it would be hard to measure
operating income? After all, the basic definition is
straightforward: operating revenues minus oper-
ating expenses. Still, different analysts can look
at the same set of revenue and expense data and
calculate different values for operating income.

The problem in calculating operating income
lies primarily in the definition of what consti-
tutes a provider’s operations (core activities).
There are at least three approaches: Opera-
tions include (1) only patient care activities; (2)
patient care and directly related activities, such
as cafeteria and parking garage operations;
and (3) patient care, directly related activities,
and government appropriations. Each definition
results in a different value for operating income.
In general, as the definition of core operations
expands, the value calculated for operating
income increases.

What do you think? Consider the hospital
sector. What activities should be considered part
of core operations? Should hospitals be required
by GAAP to report multiple measures of operat-
ing income, each using a different definition of
core activities?

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G apenski ’s Healthcare F inance98

Nonoperating Income

The next section of the income statement lists nonoperating income. As
mentioned earlier, reporting the income of operating and nonoperating
activities separately is useful. The nonoperating income section of Sunny-
vale’s income statement shown in exhibit 3.1 reports the income generated
from activities unrelated to the provision of healthcare services.

The first category of nonoperating income listed is contributions. Many
not-for-profit organizations, especially those with large, well-endowed founda-
tions, rely heavily on charitable contributions as an income source. Those char-
itable contributions that can be used immediately for any purpose (spent now)
are reported as nonoperating income. However, contributions that create a
permanent endowment fund or are otherwise limited to a specific future use
by the donor, and hence are not available for immediate use, are not reported
on the income statement. Rather, these contributions appear on the statement
of changes in net assets as changes in net assets with donor restrictions.

The second category of nonoperating income is investment income,
another type of income on which not-for-profit organizations rely heavily. It
stems from two primary sources:

1. Healthcare businesses usually have funds available that exceed the
minimum necessary to meet current cash expenses. Because cash earns no
interest, these “excess” funds usually are invested in short-term, interest-
earning securities, such as Treasury bills (a short-term debt obligation)
or money market mutual funds. Sometimes these invested funds can
be quite large—say, when a business is building up cash to make a tax
payment or to start a large construction project. Also, prudent businesses
keep a reserve of funds on hand to meet unexpected emergencies. The
interest earned on such funds is listed as investment income.

2. Not-for-profit businesses may have a large amount of endowment fund
contributions. When these contributions are received, they are not
reported as income because the funds are not available to be spent.
However, the income from securities purchased with endowment funds
is available to the healthcare organization, and hence this income is
reported as nonoperating (investment) income.

In total, Sunnyvale reported $4,113,000 of nonoperating income for
2020, consisting of $243,000 in spendable contributions and $3,870,000
earned on the investment of excess cash and endowments. Nonoperating
income is not central to the core business, which is providing healthcare ser-
vices. Overreliance on nonoperating income could mask operational inefficien-
cies such as overspending on supplies that, if not corrected, could lead to future
financial problems. Note that the costs associated with creating nonoperating

nonoperating
income
The earnings of
a business that
are unrelated to
core activities;
for a healthcare
provider, the most
common sources
are contributions
and investment
income.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 99

income are not reported separately by Sunnyvale. Thus, the expenses associated
with soliciting contributions or investing excess cash and endowments must be
deducted before the income is reported on the income statement. Other orga-
nizations may choose to report nonoperating income and expenses separately.

Finally, note that the income statements of some providers do not
contain a separate section titled nonoperating income. Rather, nonoper-
ating income is included in the revenue section that heads the income
statement. In this situation, total revenues include both operating and
nonoperating revenues.

1. What is nonoperating income?
2. Why is nonoperating income reported separately from revenues? Is

this always the case?

SELF-TEST
QUESTIONS

Net Income

The second profitability measure reported by Sunnyvale Clinic is net income,
which in exhibit 3.1 is labeled excess of revenues over expenses. Sunnyvale’s net
income is equal to Operating income + Total nonoperating income. Sunny-
vale reported net income of $6,394,000 for 2020: $2,281,000 + $4,113,000
= $6,394,000. (Not-for-profit organizations use the term excess of revenues
over expenses, but we call this measure net income because that is the more
universally recognized term. Also, one could argue that there are three
profitability measures on Sunnyvale’s income statement: operating income,
nonoperating income, and net income. We do not object to that position,
but accountants generally view nonoperating income as an entry on the state-
ment rather than a calculated profitability measure.)

Because of its location on the income statement and its importance,
net income is often referred to as the bottom line. Even though Sunnyvale is
a not-for-profit organization, it still must make a profit. If the business is
to offer new services in the future, it must earn a profit today to produce the
funds needed for new assets. Furthermore, because of inflation, Sunnyvale
could not replace its existing assets as they wear out or become obsolete
without the funds generated by positive profitability. Thus, turning a profit
is essential for all businesses, including not-for-profits.

What happens to a business’s net income? For the most part, it is rein-
vested in the business. Not-for-profit corporations must reinvest all earnings
in the business. This reinvestment of earnings increases the equity of the
organization. The relationship between net income and equity can be seen
in Sunnyvale Clinic’s statement of changes in net assets. The increase in net

net income
The total earnings
of a business,
including both
operating and
nonoperating
income.

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G apenski ’s Healthcare F inance100

assets without donor restrictions from 2019 to 2020 is equal to Sunnyvale’s
net income (excess of revenues over expenses) of $6,394,000.

An investor-owned corporation, on the other hand, may return a por-
tion or all of its net income to owners in the form of dividend payments. The
amount of profits reinvested in an investor-owned business, therefore, is net
income minus the amount paid out as dividends. (Some for-profit businesses
distribute profits to owners in the form of bonuses, which often occurs in
medical practices. However, when this is done, the distribution becomes
an expense item that reduces net income rather than a distribution of net
income. The end result is the same—monies are distributed to owners—but
the reporting mechanism is much different.)

Note that both operating income and net income measure profitabil-
ity as defined by GAAP. In establishing GAAP, accountants have created
guidelines that attempt to measure the economic income of a business, which
is a difficult task because economic gains and losses often are not tied to easily
identifiable events.

Furthermore, some of the income statement items involve estimates
(e.g., implicit price concessions) and others (e.g., depreciation expense) do
not represent actual cash costs. Because of accrual accounting and other fac-
tors, the fact that Sunnyvale reported net income of $6,394,000 for 2020
does not mean that the business actually experienced a net cash inflow of that
amount. This point is discussed in greater detail in the next section.

1. Why is net income called the “bottom line”?
2. What is the difference between net income and operating income?
3. What happens to net income?

SELF-TEST
QUESTIONS

Net Income Versus Cash Flow

As stated previously, the income statement reports total profitability (net
income), which is determined in accordance with GAAP. Although net
income is an important measure of profitability, an organization’s financial
condition, at least in the short run, depends more on the actual cash flow into
and out of the business than it does on reported net income. Thus, occasion-
ally a business will go bankrupt even though its net income has historically
been positive. More commonly, many businesses that have reported negative
net incomes (i.e., net losses) have survived with little or no financial damage.
How can this happen?

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 101

Consider exhibit 3.1. Sunnyvale reported net operating revenues of
$168,513,000 for 2020. Yet this is not the amount of cash that was actu-
ally collected during the year, because some of these revenues will not be
collected until 2021. Furthermore, some revenues reported for 2019 were
actually collected in 2020, but these do not appear on the 2020 income
statement. This is because of accrual accounting; reported revenue is not the
same as cash revenue. The same logic applies to expenses; few of the values
reported as expenses on the income statement are the same as the actual cash
outflows. To make matters even more confusing, not one cent of deprecia-
tion expense was paid out as cash. Depreciation expense is an accounting
reflection of the cost of fixed assets “used up” during the year, but Sunnyvale
did not actually pay out $6,405,000 in cash to anyone (e.g., a collector of
depreciation). According to the balance sheet (see exhibit 4.1), Sunnyvale
actually paid out $88,549,000 at some point in the past to purchase the
clinic’s total fixed assets. Of Sunnyvale’s total fixed assets, $6,405,000 was
recognized in 2020 as a cost of doing business, just as salaries and fringe
benefits are a cost of doing business.

Can net income be converted to cash flow—the actual amount of cash
generated during the year? As a rough estimate, cash flow can be thought of
as net income plus noncash expenses. Thus, the estimated cash flow gener-
ated by Sunnyvale in 2020 is not only the $6,394,000 reported net income,
but this amount plus the $6,405,000 shown for depreciation, for a total of
$12,799,000. Depreciation expense must be added back to net income to
get cash flow because it initially was subtracted from revenues to obtain net
income even though there was no associated cash outlay.6

Key Equation: Net Income to Cash Flow Conversion
Because of accrual accounting, net income does not represent an
estimate of the organization’s cash flow for the reporting period. The
following equation is used to convert net income to a rough estimate
of cash flow: Cash flow = Net income + Noncash expenses. Because
depreciation often is the only noncash expense, the equation can be
rewritten as Cash flow = Net income + Depreciation. To illustrate,
Sunnyvale reported net income of $8,206,000 and depreciation of
$5,798,000 in 2019. Thus, a rough measure of its 2019 cash flow is
$14,004,000:

Cash flow = Net income + Depreciation
= $8,206,000 + $5,798,000
= $14,004,000.

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G apenski ’s Healthcare F inance102

Here is another way of looking at cash flow versus net income: If
Sunnyvale showed no net income for 2020, it would still be generating cash
of $6,405,000 (depreciation amount) because that amount was deducted
from revenues but not actually paid out in cash. The rationale for the
income statement treatment is that Sunnyvale would be able to set aside
the depreciation amount, which is above and beyond its cash expenses, this
year and in future years. Eventually, Sunnyvale would use the accumulated
total of depreciation cash flow to replace its fixed assets as they wear out or
become obsolete.

Thus, the incorporation of depreciation expense into the cost and,
ultimately, the price structure of services provided is designed to ensure the
ability of an organization to replace its fixed assets as needed, assuming that
the assets could be purchased at their historical cost. To be more realistic,
businesses must plan to generate net income, in addition to the accumulated
depreciation funds, sufficient to replace existing fixed assets in the future
at inflated costs or even to expand the asset base. It appears that Sunnyvale
does have such capabilities, as reflected in its $6,394,000 net income and
$12,799,000 cash flow for 2020.

It is important to understand that the $12,799,000 cash flow calcu-
lated here is only an estimate of actual cash flow for 2020, because almost
every item of revenues and expenses listed on the income statement does
not equal its cash flow counterpart. The greater the difference between the
reported values and cash values, the less reliable is the rough estimate of cash
flow defined here. The value of knowing the precise amount of cash gener-
ated or lost has not gone unnoticed by accountants. In chapter 4, readers
will learn about the statement of cash flows, which can be thought of as an
income statement that is recast to focus on cash flow.

1. What is the difference between net income and cash flow?
2. How can income statement data be used to estimate cash flow?
3. What is depreciation cash flow, and what is its expected use?
4. Why do not-for-profit businesses need to make a profit?

SELF-TEST
QUESTIONS

Income Statements of Investor-Owned Businesses

Our income statement discussion focused on a not-for-profit organiza-
tion: Sunnyvale Clinic. What do the income statements for investor-owned

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 103

businesses, such as Community Health Systems (www.chs.net) and Brook-
dale Senior Living (www.brookdale.com), look like? The financial statements
of investor-owned and not-for-profit businesses are generally similar except
for entries that are applicable only to one form of ownership, such as tax pay-
ments. Because the transactions of all health services organizations are similar
in nature, ownership plays only a minor role in the presentation of financial
statement data. In reality, more differences in financial statements are attrib-
utable to differences in lines of business (e.g., hospitals versus nursing homes
versus managed care plans) than to ownership.

The impact of taxes and depreciation on net income and cash flow for
for-profit businesses deserves discussion. Exhibit 3.3 presents four income
statements that are based on Sunnyvale’s 2020 income statement, shown
in exhibit 3.1. First, note that the statements in exhibit 3.3 are condensed
to show only total revenues (including nonoperating income); all expenses
except depreciation; depreciation; and net income. Lines for taxable income,
taxes, and cash flow have also been added. The column labeled “Not-for-
Profit” presents Sunnyvale’s income statement assuming not-for-profit status
(zero taxes), so the reported net income and cash flow are the same as those
discussed previously.

Now consider the column labeled “For-Profit A,” which assumes
that Sunnyvale is a for-profit business with a 20 percent tax rate. Here, the
clinic must pay taxes of 0.20 × $6,394,000 = $1,279,000, which reduces
net income by a like amount: $6,394,000 − $1,279,000 = $5,115,000.
In the next column, labeled “For-Profit B,” the tax rate is assumed to be
30 percent, which results in higher taxes of $1,918,000 and a lower net
income of $4,476,000. The impact of taxes on net income is clear: The
addition of taxes reduces net income, and the greater the tax rate, the
greater the reduction.

Finally, let’s examine the impact of depreciation and taxes on cash
flow (net income plus depreciation). The rightmost column, labeled
“For-Profit C,” is the same as the “For-Profit B” column, except the
depreciation expense is assumed to be zero rather than $6,405,000. What
is the impact of depreciation expense? Depreciation expense lowers tax-
able income by a like amount and hence lowers taxes by T × Deprecia-
tion expense, where T is the tax rate. The amount of taxes saved—0.30 ×
$6,405,000 = $1,921,500—is called the depreciation shield. It is the dol-
lar amount of taxes that will not have to be paid because of the business’s
depreciation expense.

Let’s check our work. According to exhibit 3.3, the taxes due with-
out depreciation expense are $3,839,700, but with depreciation, they

depreciation
shield
The dollar amount
of taxes that will
not have to be
paid because of
the business’s
depreciation
expense.

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G apenski ’s Healthcare F inance104

are $1,918,200. Thus, the depreciation expense has saved the business
$3,839,700 − $1,918,200 = $1,921,500, which is the amount of the depre-
ciation shield calculated above. Also, note that the cash flow is higher by the
same amount, so the depreciation expense, which reduces taxes but does not
impact cash flow, has increased cash flow by the amount of the tax reduction
(the depreciation shield).

Key Equation: Depreciation Shield
Because depreciation expense reduces taxes, it is said to shield a for-
profit business from taxes; therefore, the amount of taxes saved is called
the depreciation shield. If a business has $500,000 in depreciation
expense and pays taxes at a 30 percent rate, its depreciation shield is
$150,000:

Depreciation shield = T × Depreciation expense = 0.30 × $500,000
= $150,000.

EXHIBIT 3.3
Sunnyvale Clinic: Condensed Income Statements Under Alternative Tax Assumptions,
Year Ended December 31, 2020 (in thousands)

Not-for-Profit
(Tax rate = 0%)

For-Profit A
(Tax rate = 20%)

For-Profit B
(Tax rate = 30%)

For-Profit C
(Tax rate = 30%)

Total revenues $172,626 $172,626 $172,626 $172,626

Expenses:

All except
depreciation $159,827 $159,827 $159,827 $159,827

Depreciation 6,405 6,405 6,405 0

Total expenses $166,232 $166,232 $166,232 $159,827

Taxable income $ 6,394 $ 6,394 $ 6,394 $ 12,799

Taxes 0 1,279 1,918 3,840

Net income $ 6,394 $ 5,115 $ 4,476 $ 8,959

Estimated cash flow
(NI + depreciation) $ 12,799 $ 11,520 $ 10,881 $ 8,959

Note: Total revenues = Net operating revenues + Total nonoperating income. NI = net income.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 105

1. Are there appreciable differences in the income statements of not-
for-profit businesses and investor-owned businesses?

2. What are the impacts of taxes and depreciation on net income and
cash flow?

3. What is the depreciation shield?

SELF-TEST
QUESTIONS

Statement of Changes in Equity

As discussed in a previous section, all or some portion of a business’s net
income will be retained in the business. The statement of changes in equity,
also called the statement of changes in net assets, is a financial statement that
indicates how much of an organization’s net income will be retained in the
business and hence increase the amount of equity shown on the balance
sheet. As Sunnyvale Clinic did in exhibit 3.1, not-for-profit organizations
often will combine the income statement and the statement of changes in
equity into a single statement called the statement of operations and changes
in net assets.

Exhibit 3.4 contains Sunnyvale’s statements of changes in equity.
Because we have simplified the financial statements presented in this book to
facilitate understanding, the statements shown here are very basic. In most
situations, the statements shown in exhibit 3.4 would contain many more
lines reflecting transactions that affect equity (net assets) on the balance sheet.

Exhibit 3.4 tells us that in 2020, the entire amount of Sunnyvale’s
net income of $6,394,000 was retained in the business. Therefore, the
equity (net assets) without donor restrictions of the clinic increased from
$39,368,000 at the beginning of the year to $45,762,000 at the end of the
year. Exhibit 3.4 also tells us that in 2020, Sunnyvale Clinic received donor-
restricted contributions in the amount of $1,466,000. Thus, the equity (net
assets) with donor restrictions increased from $6,840,000 at the beginning
of the year to $8,306,000 at the end of the year. Total net assets increased
from $46,208,000 at the beginning of the year to $54,068,000 at the end of
the year. This can be confirmed by the amount of equity shown for 2020 in
exhibit 4.1 and exhibit 4.5 (see chapter 4).

To illustrate statements of changes in equity in a for-profit organi-
zation, consider exhibit 3.5, which presents information for North River
Healthcare. Now, some portion of the earnings (net income) of the business
is paid out as dividends to owners. In 2020, the business had a net income

statement of
changes in equity
A financial
statement that
reports how much
of a business’s
income statement
earnings flows to
the balance sheet
equity account.

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G apenski ’s Healthcare F inance106

of $7,860,000, but $2,000,000 of this amount was paid to owners. Thus,
only $7,860,000 − $2,000,000 = $5,860,000 is available to increase the
balance sheet equity account. Note that, in total, the 2020 ending equity
was $54,068,000 − $50,168,000 = $3,900,000 greater in exhibit 3.4 than
in exhibit 3.5. The difference is caused by the fact that North River paid
out $3,900,000 total in dividends over 2019 and 2020; hence, the amount
retained in the business was reduced by a like amount. (For simplicity, we did
not reduce the net income in exhibit 3.5 by the amount of taxes that would
be paid if North River were a for-profit corporation.)

1. What is the purpose of the statement of changes in equity (net
assets)?

2. How does the statement differ between not-for-profit and for-
profit entities?

SELF-TEST
QUESTIONS

A Look Ahead: Using Income Statement Data in Financial
Statement Analysis

Chapter 17 discusses in detail the techniques used to analyze financial state-
ments to gain insights into a business’s financial condition. One of the most

2020 2019

Changes in net assets without donor
restrictions:

Excess of revenues over expenses $ 6,394 $ 8,206

Increase in net assets without donor
restrictions $ 6,394 $ 8,206

Changes in net assets with donor
restrictions:

Gifts and bequests $ 1,466 $ 0

Increase in net assets with donor
restrictions $ 1,466 $ 0

Increase in net assets $ 7,860 $ 8,206

Net assets at beginning of year $46,208 $38,002

Net assets at end of year $54,068 $46,208

EXHIBIT 3.4
Sunnyvale

Clinic:
Statements
of Changes

in Equity
(Net Assets),
Years Ended

December 31,
2020 and 2019
(in thousands)

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 107

important techniques used in financial condition analysis is financial ratio
analysis. In financial ratio analysis, values found on the financial statements
are combined to form ratios that have economic meaning and help managers
and investors interpret the numbers.

To illustrate financial ratio analysis, total profit margin, a ratio
that is often called total margin, is defined as net income divided by total
revenues, which includes nonoperating income. For Sunnyvale Clinic, the
total margin for 2020 was $6,394,000 ÷ ($168,513,000 + $4,113,000) =
$6,394,000 ÷ $172,626,000 = 0.037 = 3.7%. The ratio tells us that each
dollar of revenues (including nonoperating income) generated by the clinic
produced 3.7 cents of profit (i.e., net income). Thus, each dollar of rev-
enues and income required 96.3 cents of expenses. The total margin is a
measure of expense control; for a given amount of revenues and income,
the higher the net income, and hence total margin, the lower the expenses.
If the total margin for other similar clinics were known, judgments about
how well Sunnyvale is doing in the area of expense control, relative to its
peers, could be made.

Sunnyvale’s total margin for 2019 was $8,206,000 ÷ $144,800,000
= 0.057 = 5.7%, meaning that the clinic’s total margin slipped from 2019 to
2020. This finding should alert managers to carefully examine the increase
in expenses in 2020. In effect, Sunnyvale’s expenses increased faster than its
revenues plus investment income, which resulted in falling profitability as
measured by total margin. If this trend continues, it will not take long for the
clinic to be operating in the red (i.e., losing money).

Finally, let’s take a quick look at another financial ratio, operat-
ing margin, which is defined as operating income divided by net operat-
ing revenues. For 2020, Sunnyvale’s operating margin was $2,281,000 ÷
$168,513,000 = 0.014 = 1.4%. Thus, each dollar of operating revenues
generated by the clinic produced 1.4 cents of profit (operating income).
Because operating margin does not include noncore revenues (contributions

total (profit)
margin
Net income divided
by total revenues;
it measures the
amount of total
profit per dollar of
total revenues.

operating margin
Operating
income divided
by net operating
revenues; it
measures the
amount of
operating profit
per dollar of
operating revenues
and focuses on the
core activities of a
business.

2020 2019

Net income $ 7,860 $ 8,206

Less: Dividends paid 2,000 1,900

Increase in equity $ 5,860 $ 6,306

Equity, beginning of year 44,308 38,002

Equity, end of year $50,168 $44,308

EXHIBIT 3.5
North River
Healthcare:
Statements
of Changes
in Equity,
Years Ended
December 31,
2020 and 2019
(in thousands)

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G apenski ’s Healthcare F inance108

and investment income), it is lower than Sunnyvale’s total margin, which
does include such income.

A complete discussion of financial ratio analysis can be found in
chapter 17. The discussion here, along with a brief discussion in chapter 4,
is intended to give readers a preview of how financial statement data can be
used to make judgments about a business’s financial condition.

1. Explain how ratio analysis can be used to help interpret income
statement data.

2. What is the total profit margin, and what does it measure?

SELF-TEST
QUESTIONS

Key Concepts
Financial accounting information is the result of a process of identify-
ing, measuring, recording, and communicating the economic events
and status of an organization to interested parties. This information
is summarized and presented in four primary financial statements: the
income statement, the statement of changes in equity, the balance
sheet, and the statement of cash flows. The key concepts of this chapter
are as follows:

• The five types of accounts used in financial accounting are assets,
liabilities, equity, revenues, and expenses.

• The predominant users of financial accounting information are
parties who have a direct financial interest in the economic status
of a business—primarily its managers and investors.

• Generally accepted accounting principles (GAAP) establish the
standards for financial accounting measurement and reporting.
These principles have been sanctioned by the Securities and
Exchange Commission (SEC), developed by the Financial
Accounting Standards Board (FASB), and refined by the
American Institute of Certified Public Accountants (AICPA) and
other organizations.

• The goal of financial accounting is to provide information about
organizations that is useful to present and future investors

(continued)

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 109

and other users in making rational financial and investment
decisions.

• The preparation and presentation of financial accounting data
are based on the following concepts: (1) relevance, (2) faithful
representation, (3) accounting entity, (4) going concern, (5)
accounting period, (6) monetary unit, (7) historical cost, (8)
revenue recognition, (9) expense matching, (10) full disclosure,
(11) materiality, and (12) cost–benefit.

• Under cash accounting, economic events are recognized when
the cash transaction occurs. Under accrual accounting, economic
events are recognized when the obligation to make payment
occurs. GAAP requires that businesses use accrual accounting
because it provides a better picture of a business’s true financial
status.

• The income statement reports on an organization’s operations
over a period of time. Its basic structure consists of revenues,
expenses, and one or more profit measures.

• Operating revenues are monies collected or expected to be
collected that are related to the core business, namely, patient
services. Operating revenues are broken down into categories
such as net patient service revenue, premium revenue, and other
revenue.

• Expenses are the economic costs associated with the provision of
services.

• Nonoperating income reports earnings that are unrelated
to patient services, typically unrestricted contributions and
investment income.

• Operating income focuses on the profitability of a provider’s core
operations (patient services), while net income represents the total
economic profitability of a business as defined by GAAP.

• Because the income statement is constructed using accrual
accounting, net income does not represent the actual amount of
cash that has been earned or lost during the reporting period.
To estimate cash flow, noncash expenses (primarily depreciation)
must be added back to net income.

(continued)

(continued from previous page)

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G apenski ’s Healthcare F inance110

In this chapter, we focused on financial accounting basics, the
income statement, and the statement of changes in equity. In chapter 4,
the discussion of financial accounting continues with the remaining two
statements: the balance sheet and statement of cash flows. The chapter 4
supplement discusses the methods used in recording financial accounting
information.

Questions

3.1. a. What is a stakeholder?
b. Which stakeholders are most interested in the financial condition

of a healthcare provider?
c. What is the goal of financial accounting?

3.2. a. What are generally accepted accounting principles (GAAP)?

• The income statements of investor-owned and not-for-profit
businesses tend to look very much alike. However, the income
statements of health services organizations in different lines of
business can vary. The good news is that all income statements
have essentially the same financial content.

• For-profit (taxable) entities must include taxes as an income
statement expense item. Because depreciation expense reduces
operating (taxable) income, and hence a business’s tax liability,
it creates a depreciation shield equal to the tax rate times
the depreciation expense. However, as a noncash expense,
depreciation itself does not reduce cash flow, so the greater the
amount of depreciation (and therefore, the depreciation shield),
the greater the cash flow.

• The statement of changes in equity indicates how much of
the total profitability (net income) is retained for use by the
reporting organization.

• Financial ratio analysis, which combines values that are found in
the financial statements, helps managers and investors interpret
the data with the goal of making judgments about the financial
condition of the business.

(continued from previous page)

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 111

b. What is the purpose of GAAP?
c. What organizations are involved in establishing GAAP?

3.3. Briefly describe the following concepts as they apply to the
preparation of financial statements:

a. Relevance
b. Faithful representation
c. Accounting entity
d. Going concern
e. Accounting period
f. Monetary unit
g. Historical cost
h. Revenue recognition
i. Expense matching
j. Full disclosure
k. Materiality
l. Cost–benefit

3.4. Explain the difference between cash accounting and accrual
accounting. Be sure to include a discussion of the revenue
recognition and matching principles.

3.5. Briefly describe the format of the income statement.
3.6. a. What is the difference between gross revenues and net

revenues? (Hint: Think about contractual allowances/discounts,
financial assistance/charity care, and bad debt/implicit price
concessions.)

b. What is the difference between patient service revenue and other
revenue?

3.7. a. What is meant by the term expense?
b. What is depreciation expense, and what is its purpose?
c. What are some other categories of expenses?

3.8. a. What is the difference between operating income and net
income?

b. Why is net income called the “bottom line”?
c. What is the difference between net income and cash flow?
d. Is financial condition more closely related to net income or to

cash flow?
3.9. a. What is the purpose of the statement of changes in equity?

b. What is its basic format?

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G apenski ’s Healthcare F inance112

Problems

3.1. Entries for the Warren Clinic’s 2020 income statement are listed
below in alphabetical order. Reorder the data in the proper
format.

Depreciation expense $ 90,000
General/administrative expenses 70,000
Interest expense 20,000
Investment income 40,000
Net income 30,000
Net operating income (loss) (10,000)
Net operating revenues 410,000
Net patient service revenue 400,000
Other revenue 10,000
Purchased services 90,000
Salaries and benefits 150,000
Total expenses 420,000

3.2. Consider the following income statement:

BestCare HMO
Statement of Operations

Year Ended June 30, 2020
(in thousands)

Revenue:
Healthcare premiums $26,682
Fees and other revenue 1,689
Net investment income 242
Total revenues $28,613

Benefits and expenses:
Healthcare costs
Operating expenses:

$15,154

General and administrative expenses 7,874
Selling expenses 3,963
Interest expense 385
Total benefits and expenses $27,376
Net income $ 1,237

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 113

a. How does this income statement differ from the one presented
in exhibit 3.1?

b. What is BestCare’s total profit margin? How can it be
interpreted?

3.3. Consider this income statement:

Green Valley Nursing Home, Inc.
Statement of Income

Year Ended December 31, 2020
Revenue:
Net resident services revenue $3,053,258
Other revenue 106,146
Total revenues $3,159,404

Expenses:
Salaries and benefits $1,515,438
Medical supplies and drugs 966,781
Insurance and other 296,357
Depreciation 85,000
Interest 206,780
Total expenses $3,070,356
Operating income $ 89,048
Income tax expense 31,167
Net income $ 57,881

a. How does this income statement differ from the ones presented
in exhibit 3.1 and problem 3.2?

b. Why does Green Valley show an income tax expense, while the
other two income statements do not?

c. What is Green Valley’s total profit margin? How does this value
compare with the values for Sunnyvale Clinic and BestCare?

d. The before-tax profit margin for Green Valley is operating
income divided by total revenues. Calculate Green Valley’s
before-tax profit margin. Why might this be a better measure
of expense control when comparing an investor-owned business
with a not-for-profit business?

3.4. Great Forks Hospital reported net income for 2020 of $2.4 million
on total revenues of $30 million. Depreciation expense totaled $1
million.

a. What were total expenses for 2020?

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G apenski ’s Healthcare F inance114

b. What were total cash expenses for 2020? (Hint: Assume that all
expenses, except depreciation, were cash expenses.)

c. What was the hospital’s 2020 cash flow?
3.5. Brandywine Homecare, a not-for-profit business, had revenues of

$12 million in 2020. Expenses other than depreciation totaled 75
percent of revenues, and depreciation expense was $1.5 million. All
revenues were collected in cash during the year, and all expenses
other than depreciation were paid in cash.

a. Construct Brandywine’s 2020 income statement.
b. What were Brandywine’s net income, total profit margin, and

cash flow?
c. Now, suppose the company changed its depreciation calculation

procedures (still within GAAP) such that its depreciation expense
doubled. How would this change affect Brandywine’s net
income, total profit margin, and cash flow?

d. Suppose the change had halved, rather than doubled, the firm’s
depreciation expense. Now, what would be the impact on net
income, total profit margin, and cash flow?

3.6. Assume that Mainline Homecare, a for-profit corporation, had
exactly the same situation as reported in problem 3.5. However,
Mainline must pay taxes at a rate of 30 percent of pretax
(operating) income. Assuming that the same revenues and expenses
reported for financial accounting purposes would be reported for
tax purposes, redo problem 3.5 for Mainline.

3.7. Consider Southeast Home Care, a for-profit business. In 2020, its
net income was $1,500,000 and it distributed $500,000 to owners
in the form of dividends. Its beginning-of-year equity balance was
$12,000,000. Use this information to construct the business’s
statement of changes in equity. What is the ending 2020 value of
the business’s equity account?

3.8. Bright Horizons Skilled Nursing Facility, an investor-owned
company, constructed a new building to replace its outdated facility.
The new building was completed on January 1, 2020, and Bright
Horizons began recording depreciation immediately. The total
cost of the new facility was $18,000,000, comprising $10 million
in construction costs and $8 million for the land. Bright Horizons
estimated that the new facility would have a useful life of 20 years.
The salvage value of the building at the end of its useful life was
estimated to be $1,500,000.

a. Using the straight-line method of depreciation, calculate annual
depreciation expense on the new facility.

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Chapter 3: Financial Accounting Basics, Income Statement, and Statement of Changes in Equity 115

b. Assuming a 30 percent income tax rate, how much did Bright
Horizons save in income taxes for the year ended December 31,
2020, as a result of the depreciation recorded on the new facility
(i.e., what was the depreciation shield)?

c. Does the depreciation shield result in cash or noncash savings for
Bright Horizons? Explain.

3.9. Integrated Physicians & Associates, an investor-owned company,
had the following account balances at the end of 2020:

Gross patient service revenue (total charges) $975,000
Contractual discounts and allowances to

third-party payers
250,000

Charges for charity (indigent) care 100,000
Estimated bad debts (implicit price

concessions)
50,000

a. Calculate the net patient service revenue amount that would be
shown on Integrated Physicians & Associates’ income statement
for the year ended December 31, 2020.

b. Suppose the 2020 contractual discounts and allowances balance
reported above is understated by $50,000. In other words, the
correct balance should be $300,000. Assuming a 30 percent
income tax rate, what would be the effect of the misstatement
on Integrated Physicians & Associates’ 2020 reported:

i. Net patient service revenue?
ii. Total expenses, including income tax expense?
iii. Net income?

For each item, indicate whether the balance is overstated,
understated, or not affected by the misstatement. If overstated
or understated, indicate by how much.

Notes

1. Reinstein, A., and N. T. Churyk. 2012. “FASB’s ASU 2011-7 Changes
Financial Statement Reporting Requirements.” Healthcare Financial
Management 66 (2): 40–42.

2. Freudenheim, M. 2004. “HealthSouth Audit Finds as Much as $4.6
Billion in Fraud.” New York Times. Published January 21. www .nytimes
.com/2004/01/21/business/healthsouth-audit-finds-as-much-as-4.6
-billion -in-fraud.html.

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G apenski ’s Healthcare F inance116

3. Giniat, E., and J. Saporito. 2007. “Sarbanes-Oxley: Impetus for
Enterprise Risk Management.” Healthcare Financial Management 61
(8): 65–70.

4. Financial Accounting Standards Board. 2018. “Statement of Financial
Accounting Concepts No. 8 As Amended.” Published August. www
.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=11761711113
98&acceptedDisclaimer=true.

5. Financial Accounting Standards Board. 2014. “Revenue from
Contracts with Customers (Topic 606).” Accounting Standards Update
2014-09. Published May 28. www.fasb.org/jsp/FASB
/FASBContent_C/CompletedProjectPage&cid=1175805486538.

6. Holmes, J. R., and D. Felsenthal. 2009. “Depreciating and Stating the
Value of Hospital Buildings: What You Need to Know.” Healthcare
Financial Management 63 (10): 88–92.

Resources

American Institute of Certified Public Accountants (AICPA). 2014. Audit and
Accounting Guide for Healthcare Entities. New York: AICPA.

Duis, T. E. 1994. “Unravelling the Confusion Caused by GASB, FASB Accounting
Rules.” Healthcare Financial Management 48 (11): 66–69.

. 1993. “The Need for Consistency in Healthcare Reporting.” Healthcare
Financial Management 47 (7): 40–44.

Healthcare Financial Management Association. 2019. “Revenue Recognition, Includ-
ing Implicit Price Concession and Bad Debt Considerations, for Healthcare
Organizations: Accounting Issues and Trends.” Principles and Practices Board
Issue Analysis. Published January. www.hfma.org/content/dam/hfma/
Documents/PDFs/Revenue%20Recognition%20Including%20Implicit%20
Price%20Concession%20and%20Bad%20Debt%20Considerations.pdf.

Heuer, C., and M. K. Travers. 2010. “FASB Issues New Accounting Standards for
Business Combinations.” Healthcare Financial Management 64 (6): 40–43.

Maco, P. S., and S. J. Weinstein. 2000. “Accounting and Accountability: Observa-
tions on the AHERF Settlements.” Healthcare Financial Management 54
(10): 41–46.

Peregrine, M. W., and J. R. Schwartz. 2002. “What CFOs Should Know—and
Do—About Corporate Responsibility.” Healthcare Financial Management
56 (12): 60–63.

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